Estate planning for business owners includes planning for transitions

If you are an owner of or partner in a business, you may have an additional layer of estate planning to consider, especially since the business may be your family's largest asset.

Selling your interest in your business to managers or partners through a buy-sell agreement - a binding document usually drafted by an attorney - can be an effective strategy, especially since a funding mechanism can be built into the arrangement.

There are two main types of buy-sell agreements I commonly see being used today:

• Cross-purchase agreement is made between business partners. This agreement spells out the terms by which each partner may buy out the other(s) in the event of death, disability or retirement. The remaining owners buy the departing owner's share of the business at its current value.

This creates an advantage for the remaining owners. Their cost basis in their new shares will equal the purchase price. This step up in basis may reduce their potential capital gains tax liability if they decide to sell their business interest.

• Entity purchase or stock redemption agreement is established between the business and the business owners. This agreement sets conditions under which the partnership or corporation agrees to buy an owner's interest, such as the retirement or death of an owner. There is a potential disadvantage to this approach, however.

In contrast to the cross-purchase agreement, an entity purchase agreement does not increase the remaining shareholders' cost basis in the corporation. This could result in a significant capital gains tax when their interest in the business is sold.

Both types of buy-sell agreements can be funded with life insurance purchased on the lives of the partners. For cross-purchase agreements, the number of policies purchased is calculated by multiplying the number of partners by the number of partners minus one. Each business owner buys a life insurance policy on all the other owners and pays the premiums for each policy. The entity purchase/stock redemption agreement requires only one policy on each owner's life. The business is both the owner and the beneficiary of each policy and pays all premiums.

Life insurance can also be used to allow business owners to purchase polices that provide a balanced inheritance for heirs who have no interest in receiving a share of the family business. In effect, life insurance benefits equalize the value received by all heirs, those receiving an interest in the business and those who do not.

Overall, succession planning allows for a smooth transition and provides peace of mind. As always, I think it's important that you work with your financial, legal and tax advisors on what succession planning strategy works best for you and your business.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of Morgan Stanley Smith Barney LLC. He can be reached at william.a.creekbaum@smithbarney.com or 689-8704.