Part 1
BY Thomas J. Perrone, CLU, CIC
Normally, a business makes up a substantial portion of the owners’ net worth. Many business owners do not think about what will happen to their business in the event of their death or a life changing event (trigger).
This article will focus on why a buy and sell is an important document, one of the most important you will need.
We will also discuss the buy and sell agreement in the context of an S Corporation since S Corporations are extremely popular. 1
Consequences of not creating a buy-sell Plan.
- Stress on the business’ cash flow or credit line having to purchase the decedents owner’s interest
- Unqualified and instability with employees running the company
- Disagreements and conflict among heirs increasing administration time and costs
- Lack of a market for business which may potentially represent a significant value in the estate
- Suppressed value much below fair market value to raise cash for estate needs
- Termination of the business
- Instability amount employees and creditors
- Lack of liquidity to pay estate taxes and other administration costs
- Stream of income to remaining family members from the business is lost
- Valuation disagreements and IRS litigation
- Nightmares of not having a Buy and Sell agreement in a S Corporation! Loss of eligibility as a S Corporation resulting in involuntary termination of the S. Corporation status
- Most transfers to entities such as partnership, Corporation and most trusts are prohibited transfers
- A termination of S Corporation status will cause the Corporation to be taxed as a C Corporation as of the day of termination creating income tax consequences to the shareholders.
- Corporation, which is terminated, must wait five years before making a new S Corporation election, resulting in Corporation being taxed on its net profits for five years.
- The surviving shareholder could face additional tax burdens on future ongoing Corporation distribution and on those made upon the sale of the Corporation
Funding the buy and sell agreement is always a challenge to companies, because it comes down to four ways of funding a triggering event
- Borrowing money from the bank
- Using cash flow out of the business
- Life insurance death benefit
- Cash
When you compare the costs of funding the buy and sell agreement, life insurance will be the least expensive by a long shot, in most cases, especially, based on a death trigger.
Other triggers, like divorce, sudden removal from the firm, voluntary and non-voluntary removal from the firm, bankruptcy, and disability are triggers where there is not a death benefit being paid, but money is needed. In these cases, a promissory note may be used in conjunction with a term payout, or installment loan payout.
However, the cash buildup of a life insurance policy could be used as a funding vehicle especially if the policy has been in force for many years.
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