Consequences Of Not Creating A Buy and sell agreement!

Part 2 

BY Thomas J. Perrone, CLU, CIC 

S Corporations enjoy the advantages of limited liability, transferability of ownership and professional business operation and management. The S Corporation is taxed similarly to a partnership, as it is a pass through to the shareholders.  

The C Corporation is taxed at the Corporation level first. When the C Corporation is profitable and generates taxable profits. When profits are distributed to the individual shareholder it is taxed again when dividends are received by the shareholder.  

You will find S Corporations normally when the individual rates are lower than the Corporation rates. Also, losses in the S Corporation shareholders may benefit, by deduction, the losses on their individual tax returns.  

S Corporation requirement 

  • No more than 100 shareholders- members of family are considered one shareholder 
  • Must be a domestic corporation 
  • Only individuals, a decedent’s estate, estate of individuals in bankruptcy, and certain trusts are eligible shareholders of s Corporation 
  • No shareholder can be a nonresident alien 
  • One class of stock (different voting rights are allowed) 

Basis and S Corporation 

There is only one level of taxation in the S Corporation. That is at the shareholder’s level.  

If the shareholders basis exceeds the distribution, the shareholder usually will not be taxed when they receive the distribution.  

If the S Corporation has never filed as a C Corporation and has no retained earnings or profits, distributions received by an s Corporation shareholder are not subject to income tax if the distribution does not exceed the shareholder’s basis. Consequently, the larger the basis the greater amount of distribution can be taken tax-free.  

Quick overview of Basis 

  • nontaxable distributions of previously taxed income 
  • income distributed in the same year in which it was earned 
  • losses 
  • nondeductible expenditures such as life insurance expenses 

Keep in mind that the adjustments to shareholder basis is an ongoing procedure and will vary from their initial contribution to, or investment in, the Corporation. Usually, a service corporation will have a low basis because of the low initial investment made in these types of businesses.  

Life insurance to fund the Buy and Sell Agreement 

Life Insurance can have several advantages for S Corporations in a buy-sell agreement.  

A nondeductible expenditure such as life insurance premiums decreases a shareholders’ basis in an S Corporation. The cash value policy can help offset, eliminate, this adverse situation.  

Life insurance cash value helps offset the premium charged to the capital account. The cash value offsets the premium paid so that the decrease to the capital account is offset by the cash value of the policy.  

 As an example, if the premiums are $15,000 and the cash value increases by $12,000, then only $3,000 is charged to the capital account reducing the basis of the stockholder by $3,000. As opposed to having a term insurance policy with a premium of $4,000. The permanent coverage will have less effect on the basis reduction of the stockholder than the lower term insurance premium.  

Over a longer period, there will be in increase over the premium, consequently eliminating the basis reduction. In the term insurance scenario, the reduction of cost basis will continue. In some cases where the term must be renewed, or the term has an increasing premium, the lowering of the basis can be substantial.  

Death benefit and basis 

If the life insurance is set up as a redemption basis, it is possible to plan for an increase in basis for the remaining stockholders, by using a promissory note for the deceased stockholder before settling the life insurance claim. Since the death benefit is tax free income, it will increase the basis. Example:  there are three stockholders, A dies. Instead of making the claim on the life insurance, A is bought out using a short-term promissory note. Once completed, the death claim is filed, and proceeds will come in tax free for the remaining stockholders which will increase their basis. If the death benefit were used for the decedent, there would have been a wasting of the basis since the decedent’s estate would normally receive a stepped-up cost basis.  

Stock Redemption in S Corporation 

The buy and sell agreement are between the stockholders and the Corporation. The S Corporation owns the policy on the stockholders and is the beneficiary of the policy. Death proceeds to the Corporation are tax free and increase the basis of the stockholders. A big advantage to arranging the buy and sell agreement under an S Corporation is avoiding the alternative minimum taxes and the loss of basis found in a C Corporation.  

Cross Purchase buy and sell in s Corporation  

The arrangement all owners of a business agree upon in advance to purchase proportionate shares of the decedent shareholder’s interest. Each stockholder would own life insurance on the other stockholder(s) and be the beneficiary.  

  • Life insurance premium is a nondeductible personal expense 
  • Shareholders receive the death benefit federal income tax-free 
  • The surviving stockholder uses the funds to purchase the stock, which will increase the basis of their holdings, by the amount purchased.  

Some key issues:  

Section 318 Attribution Rules  

In a C Corporation, attributions can be avoided for tax purposes by arranging the buy and sell agreement under a Cross Purchase. Since the Corporation is not redeeming the stock, and it is the stockholder, attribution and the treatment of the redemption being treated like a dividend distribution is avoided.  

In an S Corporation, if the S Corporation does not have retained earnings or profits , it will have the same tax result as if the shares were sold or exchanged, allowing the shareholder to recover their basis tax-free, with any amounts exceeding. Basis being treated as capital gains.  

 A poorly structured buy-sell agreement could result in the loss of S Corporation status, as well as the possibility of increasing the surviving shareholder’s tax burden on future distributions from, or on, the sale of the S Corporation. However, there are some great advantages of setting up a proper buy-sell agreement which can be even greater advantages than those available to C Corporations.  

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Conclusion: 

The S corporation can be a great tool for many business owners as a corporate structure. A Buy and Sell Agreement must be carefully considered and drafted with consideration of avoiding the loss of an S Corporation Election.  

How The Buy-Sell Agreement Fits Within the Scope of An S Corporation!  

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 

  1. Borrowing money from the bank 
  1. Using cash flow out of the business 
  1. Life insurance death benefit 
  1. 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.  

In Part 2 we will investigate how the buy and sell agreement fits within the scope of an S Corporation.  

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Issues Of A Growing Company

This is a case study about   a company that did not have a buy and sell agreement in place.  The business has grown substantially.  The owners were concerned about the growth of the company, sacrificing larger salaries to invest and grow their business. 

The accountant recognized that there was a problem if there was a termination of a partner, and referred me to his clients to help educate  them on estate and business planning, and also to help them design a buy and sell agreement.   

Scenario:  

Bill and Sam started a very successful manufacturing company.  They produced the assemblies for hard drives. 

They are a C corporation and have scaled tahe business from four full time workers to about 34 employees. Their client base has grown from just a few to a few dozen over the years. 

One Page Issue(s) (With our team we identified these issues)

  1. The business has never been appraised so there is a question of the value of the company and estate.  
  2. Both partners have families and larger personal liabilities than when they started. 
  3. They have invested their earnings into the business and don’t have a retirement plan.
  4. They don’t have a binding buy and sell agreement, nor a method of funding the liability. 
  5. The owners are expecting the exemption credit to lower which will expose them to death taxes.
  6. Neither partner has done any estate planning, other than simple wills. 
  7. Retaining the key person in the firm who has the relationship with the customers, vendors and key contacts. Because he basically runs the company, the owners take a lot of time off.  They are concerned that the competition may try to recruit him.  If lost, it would have a major impact on the company.

Major issues and immediate concerns: 

  1. Potential fire sale of the firm if there is not a “planned design for buyout
  2. Uncertainty and instability for the employees, especially the key people in the firm.
  3. The possibility of the deceased partners family running the business with the surviving partner, leading to inexperienced leadership. 
  4. Lack of liquity to pay the taxes assessed on the value of the business and other administration costs. Without the valuation, it was a best guess estimate, jeopardizing accurate estate planning. 
  5. Business valuation disagreements, especially IRS litigation. 
  6. Lack of market for the business.
  7. The loss of income for the family.
  8. Lending from the banks could be cut off after the death of one of the owners. No  assurances that loans would be immediately available upon an owners termination. A concern that any new loans in the future may have convenants that credit lines would be redeemed upon a partners termination unless there was a valid buy and sell agreement. 
  9. Stress on the business’ cash flow or credit line  as a result of the surviving owner trying to purchase the deceased partner’s share. 
  10. The possibility of losing their key person to a competitor would be a significant loss to the firm.

One Page Solution

The most critical issues to solve now : 

  • Complete a Buy and Sell Agreement with funding/ both life insurance and disability insurance
  • A Certified appraisal to be done
  • Create strategies to keep the key person with the company
  • Start the process of personal estate planning for each partner

 There were other issues, but we all felt the buy and sell agreement was the most important at this point. 

One Page Solutions For Buy and Sell Agreement: 

  • Cross purchase buy and sell agreement funded with cross owned permanent life insurance
  • The insureds were about the same age
  • They were  both in great health
  • Premiums were about equal in cost, and the corporation would bonus the premium to the owners
  • Since the owners willl sell in the future, having the increased stepped up in basis would save taxes, as the partners plan on selling in the future.
  • Also wanted the insurance company to define full disability through the contract definition.

One Page Solution FOR KEY PERSON:  

A CEEP for the key person (Corporate Executive Equity Plan); For Key Person

  • Cash Equity for retirement
  • Tax free death benefit for family
  • Limited contribution by employee-basically paid in full by employer
  • Tax-free income at retirement- Will create about $200,000 tax free for 20 years at 66

There was a vesting schedule designed for the employee for 10 years. If he stayed he would have a much richer benefit than his 401k would provide

  • Non-compete, Non-recruiting  and solicitation of  employees of the firm,  and Non-disclosure agreement to be executed by key person

Estate Planning: 

Currently, working with the attorney on new wills, trusts, and an irrevocable trust for life insurance. There are some other things we are considering with real estate owned outside the state, such as LLC, AND inter vious trusts.

Triggers:  In the agreement we established the major triggers: death, disability, termination, retirement, divorce, bankruptcy.  We decided to use a disability income policy to fund that part of the plan.  We also wanted to have the definition of disability decided by the insurance company. 

As we move forward we are reviewing other issues yearly.  Also, forming the team with the attorney, CPA, and others was instrumental in accomplishing the results.  

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Case Examples of When To Use Life Insurance and The Type To Use!

Part 1

Part One- Two cases using life insurance.   

Over the years I have seen clients and advisors get hung up on which type of life insurance they should purchase, permanent or term insurance, making their situation much more complicated than it must be.   

In this article I want to break down the different situations where life insurance is needed and what type of life insurance I would    recommend.  Again, this is my opinion, but it is based on several facts within the situation.   

Example 1 – Young Business Owner with A Growing Business 

Our client is running a business and is investing much of his discretionary dollars into the business. His wife is a nurse and makes  good income. This helps him support the family while building his business.  

He has two young children, a mortgage, and a business loan. They are not concerned about income replacement at his death, as his wife can work anytime and anyplace as a nurse. However, they are concerned about debt, business debt and the college costs for the kids. The capital required was $1,000,000 

His earnings have been increasing consistently for the past five years, and his business has been stabilizing while growing. The income from the business is more predictable and, in a few years, he feels it will be easier to budget.  

In this case I suggested he purchase a 20-year term convertible term insurance plan.  

  •  The premiums are affordable and low  
  •  the term of the insurance would be adequate 

I could have suggested permanent life insurance under a split dollar or bonus plan however, I felt it would impede his ability to save money in his business and continue to expand. 

Case 2-The Sole Proprietor with No Market 

The problem with owning a sole proprietorship, is in many cases there is no market to sell the business. These small companies create a job for the owner, a salary, and a place to go. It affords them a good standard of living, and enjoyment in their work. The problem, however, is at their death, a long-term illness, or a cash flow crunch, or loss of key employees, they do not have a market to sell too immediately.   

One of the greatest risks is dying while owning the company.  The business is too small for the open market, and normally there are a handful of employees who do not have an interest in or the money to purchase the business.  

This is a time that the estate in many cases needs the cash to settle estate expenses.   

Competitors are more than happy to lend a helping hand by offering 10-20 cents on the dollar for the assets.   

As a planner, I can help them!  

I can arrange to have a buyer ready at any time to provide the spouse or estate of the owner, the going concern value of the business.  

  The payout would be tax free. The cost could be from 1/2% to 2% of the value put on the business.   

If the cost were 1% for example, and the business was worth $250,000, the owner would pay $2,500 a year for this guarantee.  

If the owner decided to sell the business to a willing buyer, the owner would receive back part or all their cost for the arranged guaranteed purchase.   

The “Arrangement” at death is that the spouse/estate would receive tax-free the $250,000 purchase value!    The spouse/estate could also keep the business, and sell the assets or the business (piecemeal, or the whole business). 

If the owner of the business had retired and sold the business to an outsider or another family member, the arrangement would return to the owner all the deposits the business owner contributed to the “Arrangement” over the years, plus a reasonable interest rate to help them in retirement.  

Not a bad plan when you consider the “Arrangement” is guaranteed if the business owner paid their 1% to the arrangement.  

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Business Owners Essential Planning Tools! Part 2!

Good planning can often begin with owners transferring ownership interest to family members, without giving up control of the business. This type of planning sets the stage for the future passing of the baton and can be highly effective.

The long-term plan of business transition can also focus on who can run the business operations once the senior guard leaves the business. Just because a family member has worked in the business, it does not mean they can run the business effectively.

Business Transition And Succession Planning requires many years to develop the right plan. It starts with finding the right employees to train for the job, and the right people to run the business (this includes family succession situations).  

I have found that “Passive Ownership” can be a particularly good possibility for many business owners. They stay in control and slowly give away the duties over time while running the business, but at the same time slowly disengaging from the business. It gives them time to help prepare the junior successor for the job.

The procedure for “Transition Planning” is critical for a long-lasting understanding amongst the family members, both in and out of the business. Without clear communication to the family members, conflict and bad feelings may occur. 

Business Succession Planning  (Click to receive full report and guide; R-1)

  • What would happen to the business if one of the partners died? 
    • Who will buy your interest in the business?
    • Will the company, shareholders, or the heirs keep the right to own the shares. Are the party’s mandated to buy your shares? 
    • Where will the capital to buy the shares come from? 
    • Do you want the deceased shareholders/beneficiaries to have the choice to run the business? 
    • What is the funding mechanism to buy the business? 
    • How is the life insurance structured to help fund the purchase price?
    • Is the same true for a disability? If so, what is the definition of a disability to trigger the sale. Is the disability funded?
    • What are the rules if a partner wants to sell to a 3rd party? 
    • Is there a “put” right; to have the company buy the shares of a disputed share holder? 
    • What are doing concerning incentives to key employees?
    • How are you supporting retirement through the company? 
    • What are you providing in executive compensation to the key people active owners, and officers of the business?

There are many more questions that need to be answered. The elements of your business succession plan will normally be in your business succession agreement and incorporated in the operating or stockholder’s agreement.

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Operating Agreement:  

An agreement which regulates the company and manages the relationships between the members of the company.

Buy-Sell Agreement

An agreement between the business owners to buy and sell interest in the business at a specified price upon a “triggering event”, such as death, disability, divorce, voluntary withdrawal, non-voluntary withdrawal, bankruptcy, and retirement.

This document is important and serves to obtain a fair price for the stockholder and a path for a smooth transition for the parties involved.

Type of Buy and Sell agreements:

  • Cross purchase: This is between stockholders to buy departing stockholder’s shares
  • Redemption agreement:  The entity (business) buys the shares
  • Hybrid/ a combination of above: A “wait and see buy and sell[1]

Provisions in the buy and sell agreement

The sale price of the departing owners’ interest and how it will be paid

  • Installment
  • Sinking fund
  • Cash 
  • Life insurance[2]

Other Methods To Transfer Property:

Although the buy and sell agreement is an effective method to transfer property, other methods, such as ESOPs, compensation plans, and pension plans have a place in funding.

There are other areas and issues in your business planning that need to be addressed at some point and redefined over time.

The valuation of your company should be done by a qualified and certified appraiser. Business owners seem to think they know the value of their business, however, in more cases than not, they are incorrect.

Having A Team Of Financial Experts Will Help You Plan Your Business And Your Estate.

My suggestion is to create a team of advisors who can meet periodically and report on the status of the business to the “team”.

I have found this to be a valuable tool as everyone gets on the same page in the planning process and understands what the owner wishes to accomplish. 

Over the years I have created the team consisting of the CPA, attorney, banker, investment, insurance and other professionals who come together and review what the status of the planning is up to that point for the business owner. Normally, the team consists of the professionals who have a relationship with the business owner and are currently doing planning for them. Unfortunately, each professional has their own agenda, and rarely knows what the other professional are doing for the business owner.,

In most cases this is the first time the advisors have communicated with each other. I have always thought this was in the best interest of the business owner and was prudent to use these resources. Putting the business owners’ advisors in the same room once a year could be the best planning strategy, they can employ. 

The Bottom-Line Thought

The solutions and strategies are in abundance to solve the issues. The problem is defining what the owner wants in their plan.

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[1] A combination of the redemption and the cross purchase. Usually, the stockholder or trust owns the life insurance on the partners.  Normally driven by tax issues and positioning.   

[2] Life insurance is normally the least expensive way of funding the death benefit when compared to alternatives. The life insurance can also play a role in providing funds to help stockholders purchase interest in the company. 

Business Owners Essential Part 1 Of 2

Introduction 

As professional planners, one of the most important services we can do for business owners, is to communicate to them the importance of the planning of their personal and business   assets in a coordinated effort.   My experienced is that business owners are so focused on running their businesses, they tend to neglect many parts of their personal financial objectives.     When you break it down, they have the same financial problems as individuals with the additional and complex areas of business transition and succession.    The purpose of this white paper is to discuss the various elements of their financial planning and highlight some of the critical areas.  “Key Essentials Elements” are financial areas which cannot be neglected. If the key essentials are neglected, owners are destined to financial failure, no matter how hard they work in their business, they will have a financial failure, with few exceptions.   

Many laws come out of Washington, which are relentless and never ending. There is no mercy for the taxpayer as the game keeps changing from one administration to another. Most tax policies change over time as new administrations are voted in. Consequently, taxpayers are always planning to maneuver around the tax changes to help avoid a financial disaster.  

A perfect example is the current estate and gift tax exemption which will sunset in 2025.   This will require more extensive planning, even though taxpayers have updated their estates and paid huge fees, when the exemptions were changed some years ago.  The reality is laws change all the time and taxpayers can either change with them or do nothing and face the consequences, leading to financial conundrum.     

A well-designed estate plan will consist of both the estate and business planning.   The business plan would not only consider business growth and distribution, but also, the ultimate transition and succession of the business, due to an event such as your death, disability, or retirement. 

Basic Planning documents:   

Power of Attorney, Health Care Proxy, Disposition of Remains Appointment (DORA), and Will. 

The use of a Revocable Living Trust (RLT) can be used, as opposed to a Will, for estate disposition. The RLT is a valuable tool. Assets are transferred into the trust and titled in the name of the trust.  The Grantor creates the trust, and is normally a co-trustee, keeping asset control.   The trust creates successive trustees to manage the assets in the event of your incapacity.  

A Limited Liability Company is an additional tool which may be used, in the context of your business.  

Advanced Directives Business Powers of Attorney:  

These documents deal with the unexpected disability, illness, or incapacity. It only makes sense that you should have these documents in place since the odds are great that you could have a long-term disability before age 65, and the odds only increase after that age.  

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Power of attorney (POA):  

This document names an agent(s) to manage financial affairs if one becomes incapacitated. Fiduciaries act on your behalf. They are called an “Attorney in-Fact”, and they manage financial decisions and transact business on your behalf. It is possible to have two separate power of attorney documents. One for your business, and one for your personal property. You can also appoint different people for each POA document. This makes sense because your personal representative may not have the business sense and experience to deal with some of the tasks needed when dealing with your busines affairs.  

The POA can be effective all the time or can be effective only under certain situations. This is called a “Springing Power of Attorney”.  An example of this is when the POA only springs into effectiveness when a doctor signs off on your incapacity to deal with your affairs. The person in that role should be aware of this.  

The purpose of the POA is to avoid costly and complicated court appointed guardians which is the procedure when there is no POA, and when someone is considered incapacitated. Since it is in place when executed, there is no delay upon the incapacity of an individual.  

Health care Proxy (HCP)/ also referred to Living Will.  

This appoints someone to make health care decisions if you are unable to do so yourself. Disposition of Remains Appointment (DORA): Provides a way to appoint, in writing, someone who shall control one’s final arrangements.  

WILL:  

The Will is to provide instructions on how your assets are to be distributed amongst your beneficiaries. A Will does the following:  

  • Outlines your distribution wishes- specific gifts of tangible personal property 
  • How your business is to be continued or distributed 
  • Names executive(trix) or personal representative responsible for probate accounting and filing, tax liabilities and the payment of them, and the disposition of the balance of your assets 
  • Appoints guardianships 
  • Establishes trusts to protect assets 

The Will specifies instructions regarding your intentions of the business; sold, liquidated, continue.   If your intention is to continue the business, your Will has instructions to do so. It would refer to any operating or buy-sell agreement if they exist.  

Through your Will you can establish a Testamentary Trust that will direct that your assets are managed and distributed based on your specific wishes. Assets can be managed for family members and distributed at the times you specify.  

For example, if you wanted certain property to go to certain members of your family, you can direct that. You can also preserve the principal of your assets for your children should your spouse remarry.  

Revocable Living Trust (RLT) 

A RLT can control your assets during your life and after your death. Once a RLT is set up you would transfer the title of your assets (stocks, bonds, real estate, life insurance, etc.) to the trust. You would then become of the trustee of the trust. This gives you complete control of the trust assets, and the trust. The RLT is not irrevocable until your death. You can change it anytime or collapse it if you wish. Property is not tied up in the trust, as you can change the title back to yourself in the future.  

At your death, there are no assets in your name, so, no probate. The successor trustee will gain control of your assets to distribute them according to your exact instructions. At your death assets will go directly to your heirs. No probate, so, lower estate administration costs, and no court delay in distributing your assets to your heirs.  

Along with the issue of distribution, the trustee will ensure continuity of assets management during a period of incapacity.  

Limited Liability Company.  

There are several advantages to using an LLC in the context of estate planning. 

  • Enables you to preserve significant control and management while reducing your estate costs 
  • Ability to transfer assets to family members, tax efficiently 
  • Can create significant valuation discounts using limited liability interests 
  • More income tax savings compared to estates and the double taxation of a C corporation 
  • No limit of number of shareholders   
  • No limit on the types of entities the interest of the LLC can hold 

Business Succession Planning  

The challenge of a business transition upon the death, disability, or retirement of the owner(s), is will the business survive?  This requires long term constant planning. Admittedly, transition planning is one of the of the most complex challenges in business and estate planning.  

Objectives:  

  1. Income for business owner’s retirement 
  1. Maximum but fair price for share of business 
  1. Smooth Transition 
  1. Could include compensation for family members in and out of the business  

Major Challenges 

  • Retirement for owners/income 
  • Reduction and payment of estate/State taxes 
  • Creating liquidity for the transition and new ownership 
  • Creating a formal business succession plan 
  • Family ownership and non-family ownership needs, communicated 

To be continued in Part 2 

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Life Insurance USES For Business Owners! The Uses of Permanent and Term Life Insurance!

In my very long career as a professional advisor and insurance agent, there were many occasions when I worked with CPA’s, and attorneys that were misinformed about the type of life insurance that would be appropriate in certain situations in a business arrangement.  

Many times, I found that the advisors were basing their opinions more on their personal feelings rather than the actual case fact pattern.  In most cases, when I explained to them the long-term nature of the need, or even the short-term nature, they had a better understanding of the situation, excepting my suggestion of the type of coverage to be used.    

I do believe in term insurance and that it has a place. I have used it over the years in situations where we felt the insurance benefit was only needed for an ascertainable period.   An example would be to fund a liability in a company where the company is new and does not have the cash flow to pay the larger permanent coverage.   

Another area would be when the need is temporary, such as a short-term bank loan, or an outstanding company loan.     

I have experienced clients purchasing term insurance because the premiums were very low, at least for that time frame.  I have had clients tell me they would buy term and invest the difference.  They don’t invest the difference.  They wake up one morning only to realize the term insurance started to increase in premium at an unsustainable rate to pay, and the client still needs the coverage.  Oh, yea, they didn’t invest the difference. Trust me on this, they never do.   

As a side: Term insurance was designed not to be in force when the insured dies. Insurance companies make a lot of money on term insurance because they know the policy will not be in force when the insured dies (based on their mortality data).   

Term insurance was designed to do one thing. Cover the capital liability for the period which the liability will exist.  

Now that that is out of the way, let me review some areas where permanent insurance works, and in many cases works better than any other financial vehicle.   

Business Succession:   

Many times, when I review the Business Succession Document, I find that the life insurance does not correspond to what the agreement says. Either the life insurance is underfunded, lapsed, or will be terminating soon, as it was term insurance.   

In this case permanent life insurance would have been the best solution as it has double duty dollars.  It would fund the death of an owner, help fund the retirement of an owner, or help should the owner become ill, help with income when needed.   Until the business owner transitions his position; the insurance would be needed.  This could be for many years. 

Example:  Sole Proprietor 

Many sole proprietors will tell you they don’t have a market for their business.  In essence they have a job, not a business.  However, through insurance planning, they could create a market.  For the cost of 1-3% of what the business owner feels their business is worth, there is a ready market.  At the owner’s death, the life insurance company (for 1-3% of capital), will step in and pay the family the value of the business, with tax-free dollars.   

The family also can sell the business assets without a fire sale.  Even if they sell it for pennies on the dollar, they made out better than without having the life insurance.  In this way, the business owner can keep the family in the lifestyle they have become accustomed too.  

If set up correctly, the sole proprietor could have paid the premiums through the business check book. Depending on the business structure, the premiums would be taxable to the owner, however, the cash flow comes from the business.  If the sole owner was a C Corp, they could have used split dollar and paid the taxes on the economic benefit, or the taxes on the loan regime. Either way it would have been a less expensive way of providing the market value for the company, while making sure the family received the business value, tax-free.   

This is an example of where permanent coverage is the best.  The owner of the business can also have a plan that will pay them a retirement income from the policy, while they are trying to sell the business.  An example of double duty dollars.    

The life insurance also has triple duty dollars as it can be used to help fund the costs of estate taxes, probate and settlement costs at the business owner’s death.  

PROFIT  PROTECTION 

 Most profitable organizations have key persons and key groups.  They are the people who if they didn’t come to work tomorrow, would have a negative effect on the earnings of the company.   

Once you define them, insuring them will protect your profit center.  Not only will you protect you earning and profits, but the insurance would also create new tax-free dollars at a key person’s death.  

The benefit will help the owner:  

  •  Find a replacement for your key person 
  • Fund the “usually the first one doesn’t work cost”, search for the key position and person 
  • Absorb the period where no profits are being generated by the new key person(s), for the period of the learning and adjustment period 
  • Create benefit where you can lower or eliminate turnover with your key person group 

There are “double duty dollars” using permanent life insurance.  Not only are you protecting your profits from a loss, and the cost of capital to replace, but you can also use the life insurance as an executive benefit to keep the key person from leaving the company.  The cash values of the policy can create a very rich tax-effective retirement benefit on top of the normal retirement plan.   

You can create a benefit with vesting schedules and restrictions which give the owner control over the cash values and create a benefit where you are rewarding the key person(s) with a very high retirement benefit if they stay.  This type of benefit is very effective in lowering turnover of your key people.  A salary, bonus is forgotten and expected, however, a special key person benefit is substantial and hard to walk away from.   

This again is another area where permanent life insurance works, and where term does not. 

Golden Handcuffs 

In many small companies there are key groups that are the major reason for the profits.   They know the company, know how things work, and in many cases act like an owner of the company.  They are the group that create the profits, allow the owner to live a nice lifestyle and allow the owner to come and go as they wish.   

These are the people you want to keep for life!  However, they are well known. The competition knows them very well.  Not surprisingly, the competition makes it a point to meet them when they can, such as at trade shows, industry meeting, and gatherings, hoping to test the waters to see if they can sway them away with some type of financial offer.   

They are that good, and if your competition could sweep them away from you, the owners world would change overnight.   

 THE GOLDEND HANDCUFFS  

To keep this key person or group, you need to create something they can’t afford to walk away from. A benefit so good, that even your competition would find it hard to offer to them. This is all possible by using the proper permanent life insurance policy, and the combination of well-established tax law.   

Over the years I have done many comparisons using mutual funds, annuities, stock, and company earnings, but nothing compares to the combination of a permanent life insurance policy and the tax law which allow this type of benefit.   

Using “Golden Handcuff” programs allow you to write the rules, have a vesting schedule, recover your costs, take tax deductions, and other design flexibilities.    

 By using the leverage of the tax code, and life insurance tax code, you can create a non-walkaway benefit for your profit center.   

Example:  We just finished a plan, where the key person will walk away with a substantial income at retirement.  The employee’s cost was less than $266 a year.  The employee received a large deduction and had complete control of the funds until the employee retired.  The employee would have to make over 40% ROI on his contribution to the plan in order to receive the benefits he will be receiving.   

Not only will the employee have a great retirement benefit, if he died prior to retirement, his family would have received $74,500 tax free for the next 10 years.   

As you can see, there are some very good uses of permanent life insurance, and in many cases the best and most economical solution.   

A Tax-deductible Life Insurance Plan 

One area that many small business owners are not aware of is section 412(I), where owners can design having a life insurance policy with 100% tax deductible premiums.  Normally, this is a plan that works very well with small companies and a few employees.  Again, another area where permanent life insurance works the best.  

BEWARE FINANCIAL ADVISORS: THIS IS AN EASY TAX TRAP YOUR CLIENT COULD MAKE! LEARN A FEW EXEMPTIONS AND YOU WILL STAY OUT OF TROUBLE!

 Recently, we worked on a case which involved an endorsement split dollar plani, where the split dollar agreement involving the trustee   of an irrevocable trust was terminated pursuant to a “rollout. The agreement was between the employer and the trustee (endorsement split dollar). The result would have been a “transfer of value,” in which the death benefit exceeding the consideration would have been taxable income.  

If the split dollar plan were a collateral assignment split dollar, there would not have been a  “ taxable event”, as the sale of the policy would have been made to an exempt party, the insured, (grantor and the insured are one in the same).  Under the endorsement Split dollar, the company was selling to the trustee, not an exemption entity.  

Transfer for value jeopardizes the income tax-free payment of the insurance proceeds. Under the transfer value rule, if a policy is sold for consideration, the death proceeds will be taxable as ordinary income, more than the net premium contribution.  

Besides the outright sale of the policy, there can also be a taxable event if the owner is paid in consideration to change the beneficiary. This would be a transfer of value; thus, the death benefit is taxable beyond the consideration paid for the policy. The consideration paid to change the beneficiary can be any amount.  

Consideration does not have to be money, it could be in exchange for a policy, or a promise to perform some act or service. However, the mere pledging or assignment of a policy as collateral security is not a transfer for value.  

Transfer for Value Exceptions:   

  1. Transfer to the insured 
  1. Transfers to a partner of the insured 
  1. Transfer to a partnership in which the insured is a partner 
  1. Transfer to a corporation in which the insured is a stockholder or officer (but there is no exception for transfer to a co-stockholder.  
  1. Transfer between corporation in a tax-free reorganization if certain considerations exit.  

A bona fide gift:  is not considered to be a transfer for value, and later payment of the death proceeds to the donee will be paid income tax-free.   

Part sale and gift transfer actions are also  protected under the so-called “transferor’s basis exception”  which  provides that the transfer for value rule does not apply where the transferee’s basis in the policy is determined  whole or in part by reference to its basis in the hands of the transferor.   

Another transfer for value trap can occur in the situation when you have a “trusteed cross purchase buy and sell agreement”, to avoid a problem of multiple policies when there are more than just two or three stockholders. When the trustee is both owner and beneficiary of just one policy on each of the stockholders, a transfer for value may occur when one of the stockholders dies and the surviving stockholders then receive a greater proportional interest in the outstanding policies which continue to insure the survivors. This can be remedied by either using an Entity Redemption where the Corporation purchases the interest of the deceased stockholder’s interest.  

This can also cause exposure of transfer of value when transferring existing life insurance policies, insuring stockholders to the trustee of a trusteed cross purchase agreement, which does not fall within one of the exceptions to the transfer of value rules.  To avoid this initial ownership problem, the trustee should be the original applicant, owner and beneficiary of the polices.   

Single Appraiser vs. Multiple Appraiser Choices

This month I wrote about multiple and single Appraiser choice.  My friend Ed Pratesi was nice enough to give me some of his thoughts, which I definitely respect due to his experience and training.   Ed, thank you for this contribution.

Ed Pratesi wrote:

I read with interest your comments on Single Appraiser vs. Multiple Appraiser choices that owners have for a BSA. I agree in part with your assessment that the single appraiser choice is preferred but I do have a number of caveats and suggest that before the number of appraisers needed is secondary to choices made before this decision. Let me explain my thoughts:

Firstly, the choice of number of appraisers almost always works, whether one, two or the three step approach – except when it doesn’t!

Prior to the determination of the number of appraisers needed is preceded by what I refer to as the education process that a business appraiser must take the owners through in order to develop an agreement and a process that will likely be triggered when an unanticipated or unfortunate event has occurred.

In never ceases to amaze me that owners will spend money on creating a business plan, invest in physical assets and talent and not spend enough time on one of the most important events that will occur in their lives – either their exit or a partners exit. My complaint is not pointed at the owners but at the appraiser called in to initially called in to assist in the valuation.

My point simply is the an appraiser needs to explain the valuation process, the valuation methods used to value a business, the applicability or not of the methods to the company, a discussion of the definition of value – (for example fair market value or fair value, more on this in a later discussion), a complete discussion of adjustments that appraiser consider in the valuation process, and what discounts could apply and the reasons for application of discounts.

This part of the valuation process is more consultative and sets the framework for the conduct of an initial appraisal and of the work product. Finally, once the appraisal is complete a meeting to discuss the results and the process is essential and should be prefeaced with scenario planning should a provision of the BSA be triggered.

The goal is to get buy-in on the process not just the number!

I hope I have addressed part of the discussion of the number of appraisers – more to follow if desired…

Ed Pratesi

Edward E. Pratesi, ASA, CM&AA, ABV, CVA

Managing Director | UHY Advisors N.E., LLC
6 Executive Drive, Farmington, CT  06032
D: 860 519 5648 | C: 860 558 0453 | F: 860 519 1982

epratesi@uhy-us.com |  www.uhyvaluation.com

www.linkedin.com/in/ed-pratesi-140b762

 

Single appraiser Buy and Sell Agreement!

An alternative to the multiple appraiser agreement, is the single appraiser agreement (SAA).  There are two single appraisers’ processes. I

  1. Single appraiser, select now and value now
  2. Single appraiser, Select and Value at Trigger Event
  3. Single appraiser, Select Now and Value at trigger event

The preference is #1:

However, #2,3 are stopgap processes which can be used.  As mentioned in both of these types, the value is delayed to sometime in the future. 

Postponement of the appraiser selection and initial valuation create substantial uncertainties and potential for disagreements   or disputes.

The SINGLE APPRAISER, SELECT NOW AND VALUE NOW OPTION

In the BSA, the appraiser is named and is engaged to provide an initial appraisal for purposes of the agreement.

SELECT NOW: At the creation of the BSA, the appraiser is named. All parties have a voice and can exercise their choice as difficult as it may be.

VALUE NOW:  The chosen appraiser provides a baseline appraisal for the purpose of the agreement.  In this method, it is recommended that the value be presented in draft and give each party a time period for consideration before entering it in the final BSA. 

VALUE EACH YEAR (OR TWO) THEREAFTER:  This provides great advantages:[i]

  • Structure and process
  • Known to all parities
  • Selected appraiser is viewed as independent
  • Values are seen before triggering event
  • Since a draft will be provided to the participants, they can review for corrections to the mutual satisfaction
  • The appraiser’s conclusion in known up front and is the price until the next appraisal, or until a trigger event
  • Because the process is exercised at least once, it should go smoothly when employed at trigger events, less time consuming and less expensive than other alternatives

The single valuation process also helps the estate planning process with the annual reappraisals which will facilitate the estate planning objectives of the shareholders. For example, if the planning calls for minority discounts, the supplemental valuations at the not marketable minority level for gift and estate purposes.

[i] This type of valuation process will accommodate most small companies as for many reasons listed above.