Paying the Succession Bill

Funding a buy-sell agreement: Life insurance may be the best route.

Part One of this series discussed some of the basic considerations in business succession planning, and the reasons for creating a buy-sell agreement. But putting a buy-sell agreement in place isn't the entire solution. In fact, you can have the best possible plan, but if there isn't any way to pay for the transaction to transfer ownership, you may be causing more problems than you solve.

Valuing a Business Interest

Suffice to say, without a viable formula or other means to value a business, and a regular application of the formula, there are likely to be a number of problems

Settle on a valuation process, and use it. Without proper valuation, you may be obligated to pay too much for a co-owner's interest, or you or your heirs may get too little for your interest. And, if the IRS thinks you low-balled the value to reduce capital gains, you can face penalties for underpayment.

Funding the Terms of the Buy-Sell Agreement

There are five main ways to buy a business interest:
• Pay the agreed amount out of a sinking fund
• Pay out of current business or personal income
• Use an installment agreement
• Make no plans and hope nothing ever happens
• Fund the agreed amount with life insurance

The least expensive way for many businesses to fund a buy-sell agreement is life and/or disability insurance on the owners (and key employees); sadly, most businesses choose is to do nothing and hope for the best.

Using a Sinking Fund

Few small businesses have the means or discipline to contribute regularly to a sinking fund to pay for future events. A sinking fund is a special account set aside for a future obligation, usually to pay off a bond. There are several reasons why this is not an ideal solution for funding the buy-sell. Most important: few business owners can resist raiding the account for other purposes. Also, if you're running as an "S" corporation, this option is not available, because you must distribute all income by the end of the tax year. Finally, there may not be enough time for you to accumulate the needed funds.

Using Current Income or an Installment (Loan) Agreement

When a co-owner (or key employee) leaves, dies, or becomes disabled, your company often takes a major financial hit. So, just when your revenues drop you may also be on the hook to pay him or his estate under terms of the buy-sell agreement. And, if you are counting on borrowing the money to meet the terms of the buy-sell agreement you may find you are suddenly no longer such a desirable risk.

Burying Your Head in the Sand-Hoping Nothing Will Happen

It's nice to think that nothing will happen until you or your partners have made a fortune and are ready to cash out and settle into a comfortable retirement. Dream on.

Using Life Insurance

Life insurance can do something that no other means of funding can do: As soon as you make your first payment, the entire amount is available. You aren't dependent on the vagaries of time, or good luck, or a lender. Life Insurance Funding Considerations So how does life insurance work with a buy-sell agreement, or business succession plan, or continuation arrangement?

Term Life Insurance

If you intend to leave the business within a set time frame, term life insurance with a premium that is guaranteed ("level") for a specified period is a potential solution. As long as the insurance can be converted to a permanent product, you have covered most of the bases. If you expect your business interest to rise in value, you need to make sure you can buy additional insurance on a guaranteed basis--otherwise there won't be enough to meet your obligations.

Two important considerations

Since term life insurance has no cash value, you can't miss a payment. If you do, the insurance is gone. Term life insurance is also of no real use for disability-, divorce-, or retirement-triggered buy-sell agreements since there is no cash value to borrow against. It is really a "death-benefit-only" funding means.

Permanent Life Insurance

This form of insurance is much more expensive, but it builds cash value that can be used to carry the policy if you miss a payment. The cash can also be tapped to pay disability or retirement benefits or buy out a divorced spouse. Other advantages: these policies can be written to allow the death benefit to rise to keep pace with the business value and the cash accumulation is tax-free and/or tax-deferred.

Taxes

The premiums you pay are NOT tax-deductible; the death benefits are generally tax-free.

Cross-purchase agreements

This is the simplest form of buy-sell agreement. Each owner buys a life and/or disability policy on the other owners. If there are more than three or four owners, the number of insurance policies can become cumbersome. Four owners means 12 policies (each owner buys three policies). This approach usually has minimal tax consequences.

Entity/Stock Redemption

• Where Do You Go From Here?
•  First, you need to consider having a shareholders' agreement that includes a buy-sell agreement, and you need to discuss the issues that matter to you and your co-owners-death, disability, retirement, divorce, loss of a key person, and so forth.
•  Next, talk to your business attorney and tax advisor to choose the type of agreement that make sense for your business.
•  Then talk to your tax advisor and/or a business valuation specialist to make sure you have a working valuation method in place-and use it.
•  Finally, get the agreement funded.

Careful planning can assure the future of your business, protect you and your interests, and make sure your heirs get their share of the business you worked so hard to build.