If life insurance proceeds are considered as the funding vehicle, then the proceeds of the policy received following the death of a shareholder would not be considered a corporate asset for valuation purposes.(1)
It would be recognized that it was purchased for a specific purpose of funding the buy-sell agreement (BSA). IF it were considered a corporate asset, it would offset the company’s liability to fund the purchase of shares, added back as a non- recurring expense.
Treatment 1: (used as a funding vehicle, not a company asset)
Example: A company with a $10m value, has two shareholders, owning 50% of the company. The company holds a $6m life insurance policy on each owner (assuming no alternative minimum tax issues).
RESULTS: At Shareholder #1’s death, the company collects $6m of life insurance benefits. The surviving partner will receive $10m company value, and $1m of net tax-free proceeds, a total of $11m value. The deceased stockholder receives the $5m for the business.
Treatment 2: (A corporate asset)
Treating the life insurance as corporate assets for valuation purposes.
The proceeds are treated as a non-operating asset of the company. This asset along with other net assets, would be available to fund the purchase the of shares the of a deceased shareholder. Keep in mind that the expense of the deceased stockholder might be added back into income as a nonrecurring expense. (2)
The treatment type can have a significant effect on the net position of a company or selling shareholder. There is also an affect in the ability of the company to purchase the shares of the deceased stockholder, and impact of the position of the remaining shareholders.
Company $10m, before $6m of life insurance. When you add the $6m into the value, the company value is $16m. The deceased shareholder entitled to $8m, the company pays $6m in life insurance proceeds and takes out $2m in promissory note.
RESULTS: The surviving owner, owns a company with 8 million and a note of $2 million.
Which treatment is fair? One owner ends us with $11m while the deceased owner, ends up with $5m. In treatment 2, the surviving owner has to carry a $2m debt to purchase the business. Two dramatic differences. A good reason, why the discussion should take place with your advisors.
More importantly, all parties should understand the ramifications of adding the life insurance proceeds in the valuation or using the life insurance as a specific vehicle to fund the BSA.
1. Mercer: buy and sell agreements for boomers
2. Non-reoccurring expenses: Non-reoccurring expenses can be somewhat more complex. These are expenses which is specifically designated on the company’s financial statements as an extra ordinary or one time expense. The company does not expect to continue the expense overtime, at least not on a regular basis. Non-reoccurring expenses can be somewhat more complex.