We hope you had the opportunity to join us in reading Part I of our succession planning series, “Succession Planning for Business Owners: Your Business Is at Risk Without a Plan.” As we addressed in Part I, without proper planning, the sudden death of a small business owner may have devastating impacts on your business and family. Many owners put off implementing a
business continuity plan largely because they do not want to face their own mortality, or think it
is something they can do without.
In Part II, we would like to explore the different types of popular buy-sell agreements by evaluating how they work, and the advantages and disadvantages of each. We are also assuming the use of life insurance is to be considered since we stated in Part I that over 60% of
businesses use life insurance to fund such agreements.
Entity Redemption Agreement
This plan works by having the company take out an insurance policy on the lives of each owner in the amount equal to each owner’s interest. Under the terms of this agreement, the business entity is legally obligated to buy your interest in the business from your estate, and your estate is legally obligated to sell your interest to the business at the occurrence of specified events, such as death of one business partner.
How it Works:
Agreement: The business owner(s) will work with the business’ legal, financial, and tax advisors to enter into an entity redemption agreement. This agreement requires the business to purchase the business owners’ interest in the business for an agreed upon price prior to the occurrence of a triggering event.
Premium: The business is required to purchase a life insurance policy through a life insurance provider on the live of each business owner.
Death Benefit: In the event of a death of an owner, the business will receive the life insurance death benefit income tax-free.
Purchase of Business Interest: The death benefit proceeds will be used by the business towards the purchase of the deceased business owner’s interest from his/her estate.
Pros & Cons of an Entity Redemption Agreement
This policy is perceived as efficient for multiple shareholders because only one policy is required per business owner.
The business is responsible for paying the life insurance premiums.
The life insurance cash value can be considered an asset on the business’ books.
• Surviving partners do not receive a step-up in basis, therefore, the surviving partners
may experience an increased capital gains tax in the event of exiting the business.
• Since the life insurance is funded by the company, the proceeds are viewed as an
asset making them subject to creditor’s claims
• The life insurance premiums are not a deductible expense
Each business owner buys a life insurance policy on the other owner(s) and pays the premiums
to the insurance company while being named the beneficiary to the policy. When one business
owner dies, the insurance company pays the death benefit to the surviving owner(s).
This type of agreement is commonly used when there are a small number of owners.
How it Works:
Agreement: The business owner’s will work with the business’ legal, tax, and financial advisors to enter into a cross-purchase agreement. Unlike an entity-redemption agreement, the business owners will be required to purchase the share’s of a departing business owner for an agreed upon price in the event of a death or disability.
Premium: The business owners will purchase a life insurance policy on the lives of the other
participating business owners to fund their purchase obligations. The policy owner will be the
beneficiary and pay all policy premiums.
Death Benefit: Upon the death of one of the owner’s, the co-business owners will receive the life insurance death benefit income tax-free.
Purchase of Business Interest: The death benefit proceeds will be applied towards the purchase
of the deceased business owner’s interest in the business from his/her estate.
Pros & Cons of a Cross-Purchase Agreement
The surviving business owner(s) may receive an increase in his/her basis in the business equal to the purchase price of the business interest.
Creditors may not have the ability to make claims against the cash value of the policies.
Complications arise when the business has multiple owners since each business owner has to purchase a policy on the other owners.
The business owner is responsible for all premium payments
If a wide age disparity is present among the owners, young owners may face greater premium burdens to insure older owners
Additional legal planning and the use of an insurance Trust may eliminate the need for multiple policies and still maintain a step up in basis.
Wait-and-See Buy-Sell Agreement
Under this type of agreement, the business owners delay the selection of an entity plan or
cross-purchase agreement until the unforeseen event occurs. Upon one of these events
occurring, both the company and the business owners agree to purchase the remaining
business interest at a predetermined price based on the company valuation or formula set forth
in the agreement. Wait-and-see agreements are commonly funded with life insurance policies.
How it Works:
Agreement: The business and the business owners work with a team of legal, tax, and financial advisors to enter into a Wait-and-See Buy-Sell Agreement. Upon a triggering event, the business will have the first option to purchase a business owner’s interest. If the business does not wish to exercise its option, the co-owners will have the chance to purchase the deceased owner’s interest. If the co-owners do not wish to exercise their option, the business is generally required to purchase the decedent business owner’s
interest in the business.
Premium: Business owners will purchase a life insurance policy on the lives of the other participating owners in order to fund the purchase obligation. The policy owner is required to pay the policy premiums and will be the policy beneficiary.
Death Benefit: Upon the death of a business owner, the co-owners will receive the life insurance death benefit income tax-free
Capital Contribution or Loan: If the business decides to purchase the shares of the decedent owner, the co-business owners may contribute to the death benefit proceeds they received to the business as a capital contribution or a loan
Purchase of Business Interest: The business will use the business owner’s contributions towards the purchase of the deceased owner’s interest in the business from his/her estate.
Purchase of Business Interest: In the event, the business decides not to purchase the shares, the co-business owner may exercise his/her option. The co-owner will apply the death benefit proceeds towards the purchase of the decedent owner’s interest in the
business from his/her estate.
Pros & Cons of a Wait-and-See Agreement
Flexibility is a major advantage, allowing business owners to consider the financial condition, tax consequences, economic climate, and personal family situations before making a decision
The surviving partners may benefit from an increase in their basis in the business
The implementation of a wait-and-see buy-sell is more complex than an entity redemption or a cross-purchase.
Types of Insurance To Consider
The basic types of insurance are:
Index Universal Life
Matching individual and business needs with the right product can be a major challenge for business owners. Each type of policy has a place in the market and may have dramatically different outcomes. The opinions and misinformation/understanding are similar to that of a political discussion which makes choosing a funding vehicle tougher. However, it is in the best interest of the business owner and well worth your time to understand your choices in life insurance and why one is being recommenced vs. another.
An elephant in the room that needs to be addressed is the commissions that come with insurance. Does a commissioned product effect the advice given? For true professionals, it does not. The advice necessary justifies the professional making a commission, term or otherwise. The market recognizes this and for that reason (and the true cost over time) the industry has not developed a no-load policy as in other financial products like mutual funds, etc.
It is common that other advisers such as CPAs and attorneys’ mistrust the advice provided by insurance agents causing insurance to be overlooked or not chosen. It is unfortunate when business owners cannot form a consensus on agreements or funding since there are sweeping ramifications for the surviving business owners and families in the event of a death
Exemplar’s Team Can Help Business Owners Understand Their Options
Creating an effective succession plan will solve a series of specific challenges for closely-held and family-owned businesses. Exemplar’s business succession consultants, legal team, and insurance experts understand the critical elements that need to be addressed and are committed to developing a unique plan which achieves your goals while successfully balancing disparate interests of the different owners and families.