Buy-sell Part 3: Retirement And Disability

Keeping the business going after retirement or disability

In the first two articles in this serried we looked at the ins and outs of buy-sell agreements related to death of an owner and succession planning. But there are two other essential situations to consider: Disability and Retirement.

The Retirement-Triggered Buy-Sell Agreement

Most successful small business owners plan to retire, or at least reduce their level of effort in the business. With any luck (and proper planning) they will have a hefty qualified retirement plan in place. But there’s still a lot of value locked in the business itself. The challenge is to get that value out in the form of cash. There are several ways to do this:

• Have an agreement with your partners or business associates to buy the business according to some formula at some future date.
• Have an agreement with outside parties to buy the business according to some formula at that future date.
• Plan to sell the retiring owner’s interest (or the entire business) on the open market.
• Acquire cash value life insurance on each owner, and “overfund” the cash value to allow future withdrawals and policy loans.This money can provide a retirement income stream or the funds for the business interest buy-out. OK? OR SHOULD IT BE AND/OR?

The first two options depend on two variables: the market value of your business interest and the availability of cash or financing. The third option is just plain risky. That leaves the fourth and best option, which provides funding to cash out your business interest without putting financial strain on the buyers or forcing them to find outside financing.

WARNING

Don’t count on outside financing to fund a buy-sell agreement to purchase the interest of a retiring partner. After all, the departure of a key contributor to the business’s success is not something that inspires confidence in lenders!

The beauty of this approach is that the retirement goals can be funded with the same life insurance policy(ies) used to fund the succession/death option buy-sell agreements covered in parts one and two of this series. The key is paying a high enough life insurance premium for a long enough period to ensure the policy has a cash value to support ongoing withdrawals and/or policy loans.

The Disability Buy-Sell Agreement

Amazingly, many business owners go without disability coverage. Yet, your chances of becoming disabled during your working life is anywhere from one in four to one in three--far greater than the probability of dying before retirement. And, statistics show that a disability that lasts for more than a few months will likely continue for several years or longer.

A business owner needs to think beyond replacing lost personal income. What can you do about the employees you leave behind if you can’t work? What about long-term obligations, like that three-year lease you just signed? And what about the value of your business interest? Doesn’t it make sense to insure the means to fund business obligations and your income stream—and to ensure you can get your fair share out of the business or preserve your interest if another partner can no longer work? A disability buy-sell agreement can take care of these issues. It includes:

Personal Disability Income Insurance

A complete buy-sell agreement normally specifies that each owner will acquire his or her own DI insurance policy. This is important since privately-owned (and paid for) DI income insurance generally pays tax-free benefits (but the premiums are not tax-deductible).

Business/Professional Overhead Expense Insurance

A disability may not be forever, but the damage done by the absence of an owner to the value of a business can be. Since business expenses are not part of the owner’s salary, the BOE/POE insurance policy is needed to pay these expenses until the owner can return to work or sell the business interest. The BOE/POE insurance policy covers a variety of operating expenses: Employee salaries; utilities; rent or mortgage payments; insurance; and much more. This policy normally has a fairly short (30-90 day) waiting period before it starts covering the owner’s share of the business operating expenses.

Disability Buy-Out Insurance

After a year or two, continuing to carry a disabled owner on the books gets to be an unacceptable expense for many small businesses. Unless there is a DI income policy in place, however, the business may be obligated to continue to carry the disabled owner and pay salary and benefits for an indefinite period of time. In addition, the disabled owner is often still entitled to a share of profits and maintains his or her share of the overall business. The DBO insurance policy provides a means for other owners or an outside entity to buy the interest of a disabled owner, generally over a period of years, once it is evident the disabled owner is not going to return. The payment can be a monthly amount or a lump sum.

The Consequences of “Going Without”

Any form of DI insurance is expensive. To fully insure income, expenses, and buy-out costs could entail three to five percent of an owner’s annual income.

But to go without could do one of a few things: • Violate the terms of the buy-sell agreement. • Reduce the value of a business interest, possibly to nothing. • Cause a major drag on the cash flow of a business if the income or other expenses remain a cost of the business.

Retirement income from qualified plans is one thing, but the business itself has value, and without the funding means it is difficult or impossible to get this value out; the only other options are to sell part or all of the business, fund the buy-out with current income, or try to get financing to make the payments to the retiring owner(s).

A buy-sell agreement is an invaluable planning tool, but only if it is properly and fully designed and implemented. Most businesses don’t have a plan; those that do too often stop with the life insurance funding for succession (death) planning. The successful business owner covers all the bases, including retirement and disability planning.