Life Insurance Proceeds In Business Valuations

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.

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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. 

The Interplay Between the Funding Mechanism And the Valuation? 

What happens when life insurance proceeds are part of the funding vehicle of a buy and sell agreement (BSA).    

 Example 

 When a stockholder owner dies and life insurance payments are made, is the valuation of the stock being redeemed as part of the value of the company?   

The way life insurance benefits are treated in the buy and sell agreement (BSA), could lead to different estate treatment and income tax.    In both areas, the results can be dramatic.     

 Does the agreement tell the appraisers how to treat the life insurance benefits in their valuationDoes the agreement provide for the company to issue a promissory note to a deceased shareholder, and what are the terms? 

 Keep in mind, the agreement is no better than the ability of the parties and/or the company to fund any required purchases at the agreed upon price.    An agreement that is silent on this issue is like not having an agreement.  

 Life insurance  

 Generally, life insurance premiums are not deductible, and the pass through of non-deductibility can create pass-through income for the shareholders of S corporations, and the owners of partnerships and limited liability companies.  Knowing how to treat the life insurance premium for tax purposes would be important information for you.  We suggest you discuss this with your CPA.  

 Although the life insurance premium is not deductible, the death benefits generally are tax- free, notwithstanding the alternate minimum tax treatment for C corps.  

Keep in mind the funding mechanism is not actually necessary to define the engagement for valuation purposes and has nothing to do with appraisal standards or qualifications. It provides the funding for the company to afford the value, and to make sure the selling stockholder receives the value.  In essence, it’s the mechanism to fund the liability of the contract, or at least part of it.   

Wants and Needs of the Buyer and the Seller- The normal push and pull!  

The seller wants the highest price and the buyer wants the lowest price.   Without a doubt the best time to set the price would be prior to a triggering event, when both parties are in parity and neither is the subject of the trigger.  It is the best time when both parties will be the most reasonable in setting the rules of the agreements as they are both fair minded in the negotiations.   

 Funding Methods 

  1. Life InsuranceIn most cases life insurance will be the most inexpensive method for funding the death benefit part of the agreement, when comparing, self funding, and loans (including corporate promissory notes) to fund the liability, notwithstanding the ability to get a funding loan from a loaning institution.    In most of the comparisons I have done over the years, life insurance is the least expensive, most guaranteed, and the easiest method of funding for death benefit purposes. 
  1. Corporate Assets: They would have to be accumulated for this purpose, and would likely be included in the valuation, and also would be subjected to taxes during the accumulation stageWhat if the death of the stockholder occurred early after the agreement?  Would there be funds available to fund the liability of the agreement, as there would be a lack of time to accumulate the necessary net profits for the funding?   
  1. External borrowing: Depending on the company’s financial position, it may be possible to fund the purchase price by borrowing.  However, this should be negotiated in advance and before its needed.  Remember, the time to requests funds from an institution is when you don’t need them.  Also, on the other side of this funding element, is the possibility the loan covenant requesting the outstanding note balanced to be called in when there is a dramatic change in ownership and management.    The lending institution may be questioning the ability of the company’s future financial position and the ability to stay profitable.   
  1. Promissory Notes:  If this is going to be used, the terms of the notes should be in the agreement.  Although cash payments are preferable to the seller.   
  1. Combination of cash and promissory notes: Important to note:  Anytime capital is being used by the corporation, it is important not to unreasonably impair the capital of the business. Many state laws prohibit transactions that could impair capital and raise the question of insolvency.  

Without the mention of what funding mechanism is being used in the agreement to repurchase shares, lessens the value of the agreement.  Also, with stated funding, the economic or present value of the redemption price set by the agreement can significantly be reduced, because of inadequate interest or excessive risk leveled on the selling shareholder.   

  

Weak terms in the agreement of the funding mechanism diminishes the value of the agreement from the sellers prospective. However, terms that are too strong can taint the future transactions. What is clear is that it is essential for the parties to discuss the funding mechanism for the triggers of a BSA, keeping in mind both the sellers value position and the purchaser’s ability to fund the costs. 

A Road Map For A Succession Planning  Essentials For Planning   Creating Your Team Of Advisors 

Who Are They 

Their Role 

Accountant 
  • Develops financial statements 
  • Provides tax advice 
  • Assists in Estate planning 
  • Assists in Business value 
Attorney 
  • Negotiates agreements 
  • Tax Advice 
  • Prepares estate documents 
  • Advises on business structure along with implementation 
Management Team 
  • Manages the ongoing operation  
  • Operational advice and expertise for new owner 
  • Enables business continuity 
Business Appraiser 
  • Estimates fair market value of Business  
  • Provides the credibility of asking price 
  • Advice on how to maximize business value 
Business Broker 
  • Finds buyer and market insight for value 
Financial Advisor 
  • Facilitates and council’s family goals and value 
  • Plans for the future of the estate and distribution 
  • May have the capacity to help fund Buy and Sell Agreements and Deferred Compensation situations 
  • Offers financial advice to all the members 
  • Helps project future financial needs 
Banker-Commercial 
  • Financing options for acquisition 
  • Access to other experts that may be needed 
  • Supports the business transition before and after the acquisition 

Exit Options: 1 

  • Transfer the business to a family member; This represents about 42% 
  • Sell to partners or your employees (directly or through ESOP); This represents about 17% 
  • Sell to a third party; 19% 
  • Partner: 10% 
  • Wind down business -3% 
  •  Don’t know -8% 

Questions To Consider 

  1. Are there one or more family members who want to take over the business?  
  2. Does the family successor have the skills to operate the business and guarantee the return on your investment?  
  3. What are the qualifications and skills someone would need to purchase your business to guarantee the successful transition?  
  4. If you transitioned to your family member, how will your employees, suppliers and customers react?  
  5. What is the most tax-efficient way to pass ownership to family members?   
  6. Will you continue to have a role in the business? 
  7. How will this succession option impact the rest of the family? 

Selling to partners or your employees 

  • Which employees or partners are best suited to purchase your business?  
  • Do they have funds or access to funds?  
  • Will you have to finance part of the sale?  
  • Do they have the management capability to run the business successfully?  
  • Can the business take on debt for this transaction long term?   
  • Where will the purchase price come from?  
  • Do the purchasers have assets as collateral?   

Third party  

  • Who are likely candidates in your industry that would be interested in your business?  
  • Do you want to sell the whole business or only part of it?  
  • Will the potential buyer have the entire financial resources to purchase the business, or would you be prepared to partially fund their acquisition?  
  • What is the most tax-effective way to sell your business?   

 

Case Study#5 Using Corporate Dollars To Keep Wealth Out Of The Business But In Your Pocket

This is the case of Joey Bag of Donuts and his pursuit of keeping wealth outside of his business.  You see, over the years working with Joey Bag of Donuts we told him that leaving too much of his wealth in the business can be problematic, especially when the time came when he needed to exit his business.  He heard me tell him many times, that someday he will leave his business by either a death, disability, or retirement, and taking the wealth with you when you need it the most, can be a problem, if you don’t have the right exit strategy.

There are many reasons wealth gets lost in a business when it is sold.  It can range from bad planning to bad luck, but Joey Bag of Donuts always remembered to keep as much of his personal wealth outside of the business as possible.  By the way this is why he purchased his company building and put it in a separate LLC.  Joey Bag of Donuts also believes in putting as much of his income to the company pension plan, again, outside of the business.

We also taught him to have his company support whatever it can legally towards his personal lifestyle.  For example, his cars, gas, some entertainment, health insurance, retirement, and other things are paid for through company.

Joey Bag of Donuts wanted to put more money away for himself and his family’s future, but didn’t want to use his own funds, so why not have the company support more retirement contributions?

We already had a profit-sharing plan, and he was sharing company contributions with his employees.

We decided that a non-regulated plan was the best way to go, so we developed a plan for only him.  The plan is a combination of two concepts.  We call this the CEEP PLAN (CORPORATE EXECUTIVE EQUITY PLAN).

The plan is a discriminatory plan, so Joey Bag of Donuts can pick himself or anyone else he wants, unlike a profit sharing or 401k plan, which is a regulated plan.

THE PLAN:  As you can see, the company made all the contributions, and took the deductions for them.  Joey Bag of Donuts was the sole participant of the plan. His cost was “0” out of pocket and he ends up with almost $800,000 of cash at retirement.  He also could turn the cash into a tax-free income stream.  In this case it was $67,500 tax-free income. The stream of income is worth more than $1,215,000.  Along with that he has a death benefit of $2,300,000 payable to his family tax-free.

THE BOTTOM LINE:  Joey Bag of Donuts gets retirement income using corporate funds.  All the contributions can be applied to just his account.  He also has the use of the account before retirement, like a  “family bank”, along with the ability to withdraw funds tax-free.[1]  There would be no 10% penalty if withdrawn before 59 ½.  Continue reading “Case Study#5 Using Corporate Dollars To Keep Wealth Out Of The Business But In Your Pocket”

THE SECRETS OF BUILDING A GREAT ORGANIZATION

I recently read a book called,” The Secrets Of Building A Great Organization”, by Bruce Clinton owner of BusinessWise, L.L.C., a business consulting and coaching firm based in Connecticut.

I found the book to be very interesting because, not only does it provide a road map of management for newer managers, but it re-educates older experienced managers in the most up to date strategies.

Bruce is the first person to mention that there are no magic formulas in being a good manager, however, with the basic strategies that he covers, a good manager, through their own talents, can become a great manager using the strategies Bruce discusses.

Many of the strategies are ones that Bruce uses in his practice as a business coach, and strategies developed while he ran different businesses.

For anyone who is a business owner or running a business, I would suggest this read.  In the book it is mentioned that most business owners don’t consider themselves good managers or they feel they don’t know enough about managing.

Any business owner who does $1-$150 million in annual sales, has 8-200 employees, is family owned and may be facing growth or succession issues, should read this book.

What I really enjoyed about the book is the small details that Bruce covers which are needed to build a successful business.  These are details which are not normally discussed in detail.  The book covers the importance of them.  These are the small details that make all the difference in the world of a business’ success, and Bruce covers them extremely well.  For example:

  • Overcoming communication breakdowns
  • Dealing with levels of incompetence
  • Fitting family members into the business
  • Retaining good employees
  • Building a workable succession plan

Continue reading “THE SECRETS OF BUILDING A GREAT ORGANIZATION”

Why Use Non-Compete Agreements!

Non-compete agreements (NCA) represent a separate agreement. They could be in an employment contract, or as a separate article in a buy and sell agreement. Sometimes they are referred to as Covenants not to complete. “

This is based on the possibility that an employee can do harm to a company upon termination.  They could know sensitive information about the company’s operation, owners and employee’s personal information, special operations, and proprietary information to a competing advantage, along with so much more.

Picture a very long-term employee working side by side with the owners, for many years, and then leaving to work for the owner’s competitor.  Certainly, there can be issues.

No compete agreements (NCA), can be used to retain employees also.   It would be very difficult to change jobs within an industry or profession when the leaving employee is limited to compete in a geographic and specific industry for a period of time.  However, non-compete agreements are hard to enforce, because in many instances the agreement has overreached and is very broad in the definition of industry and geographic coverage.

Continue reading “Why Use Non-Compete Agreements!”

What Status Is The Stock After A Triggering Event?

Chris Mercer author of “Buy-Sell Agreements for Baby Boomers Business Owners” addresses a very good question.  Who owns the stock after the trigger event?  After a trigger event, does the affected shareholders retain the rights, risks and privileges of the ownership, things like, voting, distribution, access to financial information, etc., or are their shares converted to another status, such as (example), the “pending sales of stock” status?

If the shares are converted into the new class or status, do they have the right to receive dividends, or interest while in that pending status, if so, who should be receiving it?

The agreement can also have a clause where the stock that is waiting to be purchased would convert to a “non-voting “status prior to being purchased.

There are many times a stockholder has signed personally for a corporate debt.  The stockholder may desire to have the remaining stockholders make an effort to get the departing stockholder off the note, as they have ceased to be a stockholder.

The questions that Chris puts forth are legitimate issues and should be dealt with when business owners and their council set out to design a buy and sell agreement for the company.

Thank you, Chris Mercer, for bringing these topics to the forefront.

Over the years, many of the buy and sell agreements which I have reviewed over the years, do not address or mention these particular situations, and could create a void should the situation arise.

Check Chris Mercers publications.  He puts out very good information that is useful to practitioners.