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Designing And Funding Succession And Exit Plans For Successful Business Owners, Part 1

Succession and exit planning for owners of successful businesses is crucial yet challenging. A business owner is typically focused on the bottom line and tied up in the operations of the company. Less immediate issues like ensuring that the business will thrive when he/she is not around, securing a comfortable retirement, providing for the family if something unexpected happens, treating children fairly, and leaving a legacy are critically important to address but receive little, if any, attention.

With the help of his trusted advisors, the business owner must understand that, only with proper planning today can the family maximize and protect the value of the years of hard work he/she has put into the company. Attention must be paid to planning for retirement, transitioning to a lesser role in the company, and the impact of his/her own mortality.

A comprehensive succession and exit plan considers the central role that the business plays in an owner’s overall financial, retirement, and estate plan. When approached on a total needs basis, succession and exit planning present opportunities for the business owner and his advisors to address:

  1. Business continuation. Transitioning the business to a family member, key employee, or third party.
  2. Executive retention. Ensuring continued success of the business through retention of key employees using special benefits (Golden Handcuffs).
  3. Retirement. Securing a comfortable retirement (which is, perhaps, not primarily dependent on the business).
  4. Legacy issues. Preserving the business for family members or monetizing its value to provide financial security for surviving family members while treating heirs fairly.

This is the first of a four-part series addressing succession and exit planning. It is focused on five common business owner situations and the planning strategies to consider in each one. It can help the owner and his advisors determine which type of continuation arrangements to consider depending on the situation at hand. It also contemplates how cash value life insurance is used to strategically fund succession plans. Life insurance often plays a major role in the financial stability of businesses for the same basic reasons as that of an individual: protection against premature death or disability, or retirement, and the delivery of cash exactly when it’s required.

Situation #1: The business has multiple owners who want to eventually sell their interests to each other.
A Buy-Sell Agreement is a legally binding contract which states that upon the occurrence of a “triggering event” (typically an owner’s death, disability, retirement, or otherwise separation from the company), the owner’s interest in the company must be sold back to the business or to any remaining owners at agreed upon terms. These agreements are crucial for small and closely-held companies, as in many cases, the void created by death or departure of a business owner creates a significant financial burden on the business as well as the remaining partners.

When structured properly, a Buy-Sell Agreement allows for continuity of management, a source of income for the business owner and his family, and a clear direction for future ownership of the business.

Depending on the type of Buy-Sell Agreement, the business itself or the individual partners acquire a policy on each owner/partner so that upon the occurrence of the triggering event, the funds needed to “buy out” the individual’s ownership interest are readily available. To limit this potential risk, most Buy-Sell Agreements are funded with permanent life insurance policies that provide a death benefit in the event of demise as well as a cash value component upon disability, retirement, or departure of the owner.

A Cross Purchase Buy-Sell is a specific type of continuation plan best suited for businesses that have only a few owners who want to eventually sell their interests to each other. A Cross-Purchase Buy-Sell Agreement states that, at the occurrence of a triggering event, the departing owners or the estates of the decedent business owners must sell their interests to the remaining owners at an agreed upon or determinable price. The agreement can apply to one or more of the owners; not all have to participate.

The participating owners typically purchase cash value life insurance policies on each other in order to fund the future purchase obligation. Each participating owner pays the premiums and is the owner and beneficiary of their respective policies. At an owner’s death or departure from the company, the other participating owners use the life insurance death benefit proceeds (at an owner’s passing) or cash surrender value (in case of disability or retirement) to purchase the owner’s interest. This allows the remaining owners to continue the business with minimal interruption and the departing owner or his estate to walk away with cash.

From a tax perspective, it is interesting to remember that the purchasing owners may receive an increase in basis equal to the purchase price of their new interest, but the cash value of the life insurance policy owned on co-owners’ lives may be included in the decedent business owner’s estate.1

Since each owner buys a policy on the others, too many participating owners may result in an overwhelming number of life insurance policies. To address this problem, an Entity Purchase Buy-Sell (Stock Redemption) can be used for companies with multiple (three or more) owners who want to eventually sell their interests to each other. The Entity Purchase Buy-Sell requires the business itself, rather than the owners individually, to purchase the participating owners’ interests when a triggering event occurs.

The business is the purchaser and beneficiary of cash value life insurance policies on each of the participants’ lives to be used to fund the future purchase obligation. Upon the triggering event, the business uses the life insurance death benefit proceeds or cash surrender value to purchase the business owner’s interest in the company leaving the departing owner or his estate with cash at just the right moment.2

Situation #2: The business has multiple owners who want to eventually sell their interests to each other, but the intent may or may not be mutual, so flexibility is desired on how the purchase is ultimately handled.
When flexibility is worth a bit more complication, a Wait-and-See Buy-Sell allows the participating business owners to postpone the choice between Cross-Purchase and Entity Purchase Buy-Sell until the death or departure of an owner. It requires the business and the participating owners to purchase the interests at an agreed upon or determinable price upon the occurrence of a triggering event. Usually the business is given the option of first right of refusal; the remaining participating owners can purchase any portion not taken by the business.

The participating owners purchase and are the beneficiaries of cash value life insurance policies on the lives of the other participating owners. At the first owner’s death or departure from the company, the business decides whether to exercise its purchase option. If it does, the participating business owners contribute funds from the life insurance death benefit proceeds or cash surrender value to the business. The business purchases all or a portion of the shares and the remaining participating owners receive an increase in tax basis equal to their share of the contributions.3

If the business waives its Entity Purchase option or only purchases a portion of the shares, then the Cross-Purchase option may be exercised by the participating business owners. Any outstanding shares must be purchased by the business and funded with contributions from the remaining business owners.

Situation #3: The business has multiple owners, some of whom have intent to sell their interests to each other, but the intent is not mutual.
A One-Way Buy-Sell is designed for the owner of a business who may want to sell to someone who does not have current ownership in the business or to one or more co-owners that have no reciprocal intent to sell. The One-Way Buy-Sell allows the business owner to have a willing buyer for the interests in the business, the sale of which may provide a source of income for the business owner’s family. The buyer is usually a key executive, family member, or third-party to whom the business owner wants to transfer the business. It ensures that the owner can sell his interest to an appropriate buyer, because the agreement requires the buyer to purchase the participating owners’ interests at an agreed upon or determinable price upon the occurrence of a triggering event.

The buyer purchases a cash value life insurance policy on the business owner’s life to fund the future purchase obligation. The buyer pays the premium and is the beneficiary of the policy. The business may provide the buyer (especially if it’s a family member or key employee) with a taxable bonus in order to assist with the premium payments. At the owner’s death or departure, the buyer uses the life insurance death benefit proceeds or cash surrender value to purchase the business owner’s interest.

An Entity Purchase Buy-Sell could also be worthwhile to consider in this situation, because it obligates the business, rather than the co-owners, to buy out the decedent or departing business owner’s interest in the company. Please refer to description, above.

Situation #4: The owner wants to sell business interests to a non-owner, such as a family member, key employee, or third party.
Consider a One-Way Buy-Sell; please refer to description, above.

Situation #5: The owner has no readily available successor or buyer of the business interests, and would consider having the business become employee-owned.
An Employee Stock Ownership Plan (ESOP) is a special type of tax qualified profit-sharing plan that invests primarily in employer securities. If an S or C-Corporation owner does not have an heir, co-owner, or outside buyer interested in taking over the business, or wants the business to end up being employee-owned, an ESOP can be a way to create a source of funds to buy-out the owner’s interest in the company.

Not only does the Employee Stock Ownership Plan create a buyer for the owner’s stock, but a C-Corporation business owner can use the sale proceeds to purchase qualified replacement property and defer taxation on the sale of the stock to the Employee Stock Ownership Plan. This allows the owner to sell all or a part of the business to the Employee Stock Ownership Plan without immediate taxation and to use the proceeds to diversify assets through the purchase of qualified securities.

After a company feasibility study is conducted and approved for an Employee Stock Ownership Plan, the company establishes and makes tax-deductible contributions to a trust. All full-time employees with a year or more of service are typically included. The company contributes new shares of its own stock or cash to buy the existing shares of stock from an owner who desires to sell. In today’s low interest rate environment, it may make sense for the Employee Stock Ownership Plan to borrow the money to buy new or existing shares, with the company making cash contributions to the Employee Stock Ownership Plan to repay the loan.

Once the stock is in the Employee Stock Ownership Plan, it is allocated to the accounts for the individual employees on a non-discriminatory (qualified) basis and it vests over time. When employees leave the company, they receive the vested Employee Stock Ownership Plan shares, which the company is typically required to buy back at an appraised fair market value.

Cash value life insurance owned by the company is oftentimes used to fund the company’s repurchase obligation. Policy cash values can accumulate tax-deferred and can potentially be accessed income tax-free for annual stock repurchases. In addition, any death benefit proceeds paid may be received by the company income tax-free, and can create an immediate source of funds for stock repurchase in the event of an untimely death of a major participant or shareholder.

I hope you found this article intriguing. Part 2 of this four-part series will address executive retention as a way ensure the continued success of the business through attracting, rewarding and retaining key employees with special benefits.

1 Neither Grant, Hinkle & Jacobs nor Insurance Thought Leadership is a tax or law firm and this is not meant to be relied upon as tax advice or to avoid IRS penalties; please consult your tax and/or legal professional before embarking on any business succession plan.

2The death benefit proceeds, although typically income tax-free to beneficiaries under IRC §101(a)(1), are taxable to the employer unless it qualifies for an exception under IRC §101(j).

3 See 1, above.

4 See 2, above.

Uses of Life Insurance in Estate Planning

Most people think life insurance is used for only one specific purpose: to replace the lost earnings should a primary breadwinner pass away. Those who subscribe to this theory often purchase low-cost, term insurance that expires soon after retirement. However, such thinking ignores the wide variety of uses for life insurance, especially when it comes to estate planning. Let’s examine several alternative uses of life insurance that many perhaps overlook.

1. Estate Creation – One of the most obvious, yet most overlooked, uses of life insurance is to create or expand one’s estate. Every parent wants to leave their children better off financially than they were. Life insurance can create an immediate estate for one’s children, often for pennies on the dollar. In uncertain economic times, life insurance can be an important resource to ensure our children’s economic well-being.

2. Liquidity to Pay Estate Taxes – The truth is, the IRS expects all estate taxes to be paid off within 9 months of your death. Federal estate taxes can be as high as 50% of your gross estate. The average Californian’s estate is dominated by two assets: their personal residence and their Individual Retirement Account. Neither of these assets is easily liquidated on short notice without triggering substantial tax penalties. Even if your heirs were able to liquidate one or more of these assets to pay taxes, using life insurance proceeds instead may make far greater sense.

3. Estate Equalization – In many families, the bulk of their estate is comprised of assets that aren’t easily divided among heirs, such as the family residence. Often, one heir has expressed an interest in preserving the asset, while others would prefer cash instead. Life insurance may allow you to divide your estate equally among your heirs, while reducing the need to divide assets or provide for joint ownership.

4. Family Business – Many parents who have invested their life’s work in their own business dreams that one day their children will follow in their footsteps, and take over the day-to-day management of the company. Often, this simply isn’t the case. A more typical scenario involves one child having an interest (or ability) to take over the family business, while one or more other siblings are interested in pursuing their own life goals. Forcing all your children, regardless of their interest (or business acumen) to participate in running the family business for the sake of receiving their inheritance is often a recipe for disaster. A far more sane (if less sentimental) approach is to hand over the reins of the family business to the child who shows the most
interest/ability. Using life insurance to “cash-out” the other heirs is an ideal way to preserve family harmony, as well as the continued viability of the family business.

5. Wealth Replacement – For many families, philanthropy is an integral part of their value-system. These values are often reflected in their estate plans through sizable bequests to charities upon their death. In such cases, amounts transferred to charity may reduce the inheritance of loved family members. An alternative is to use life insurance to replace the assets given to charity in a cost-effective manner. Such win-win thinking helps to preserve family harmony, while instilling the value of philanthropy in the next generation.

In Conclusion

In each of these scenarios, we can see valuable uses of life insurance that extend far beyond mere “paycheck replacement.” We have yet to meet the family that couldn’t relate to one or more of these examples. Which one applies to your situation? I welcome the opportunity to discuss your needs in more detail.

Important Note:

When using life insurance in estate planning, it is important to use an Irrevocable Life Insurance Trust (ILIT) to own the life insurance policy. This means that the proceeds of the life insurance policy will be paid directly to the beneficiaries of the ILIT free of estate or income tax.

Without an ILIT, a life insurance policy would be included in your gross estate, and your estate tax liability would be increased, not decreased.