Buy Sell Fundamental

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Basics on Buy-Sell Agreements

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Buy Sell Fundamental

  1. 1. Buy-Sell Arrangements The Basics and Beyond
  2. 2. What is a Buy-Sell Arrangement? <ul><li>It is an arrangement between owners for the sale of the business in the case of death, disability, or retirement. </li></ul><ul><li>It protects the interest of the owners and helps ensure the continuation of the business. </li></ul>
  3. 3. Why do you need a buy-sell arrangement? <ul><li>Sometimes businesses, like marriages, do not pass the test of time and a disagreement between owners may result in the end of a business. </li></ul><ul><li>A buy-sell arrangement can prevent the loss of a business that owners worked so hard to create. </li></ul>
  4. 4. Prospects for Buy Sell Planning <ul><li>82% of small business owners are over the age of 40. </li></ul><ul><li>39% of all small businesses will see a change in leadership in the next 5 years. </li></ul><ul><li>10-15% increase in the number of small businesses expected over the next 5 years. </li></ul>www.limra.com
  5. 5. Buy Sell Plans in Place <ul><li>4 out of 6 businesses own life insurance for business purposes such as key person. </li></ul><ul><li>60% of firms with succession plans fund them with life insurance. </li></ul><ul><li>Only 6 out of 10 businesses have formal succession plans in place. </li></ul>www.limra.com
  6. 6. How Does It Work? <ul><li>The owners enter into an written agreement which will protect the interests of all owners and family members. </li></ul><ul><li>The business owners fund the agreement according to its terms. </li></ul>
  7. 7. Business Profile <ul><li>All closely-held businesses </li></ul><ul><ul><li>Sole Proprietorships </li></ul></ul><ul><ul><li>Partnerships </li></ul></ul><ul><ul><li>S Corporations </li></ul></ul><ul><ul><li>LLCs </li></ul></ul><ul><ul><li>C Corporations </li></ul></ul>
  8. 8. Goals of Good Buy-Sell Agreement <ul><li>Guarantee a Buyer </li></ul><ul><li>Create Liquidity </li></ul><ul><li>Set a Fair Selling Price </li></ul><ul><li>Fix the Value </li></ul><ul><li>Maintain Harmony </li></ul>
  9. 9. Types of Buy-Sell Arrangements <ul><li>Cross-Purchase </li></ul><ul><li>Entity Purchase </li></ul><ul><li>Wait and See </li></ul>
  10. 10. Cross Purchase <ul><li>Cross purchase is an arrangement in which each of the owners agrees to buy out the others. </li></ul><ul><li>It is a business continuation agreement between the individual owners. </li></ul><ul><li>Works best with three or fewer owners. </li></ul>
  11. 11. Funding Cross Purchase <ul><li>Requires multiple policies </li></ul><ul><li>N*(N-1) (n=owners) (5 owners, 20 policies) </li></ul><ul><li>Individual owners may pay premiums out of their personal funds </li></ul><ul><li>Corporation may pay premium using split dollar or bonus arrangement </li></ul><ul><li>Owners receive death benefit income tax free </li></ul>*Life insurance death proceeds are generally excludable from the beneficiary’s gross income for income tax purposes. There are a few exceptions, such as when a life insurance policy has been transferred for valuable consideration.
  12. 12. Advantages of Cross Purchase <ul><li>Purchasing owners receive a step-up in basis </li></ul><ul><li>Life insurance proceeds are received income tax-free </li></ul><ul><li>Life insurance proceeds do not increase the value of the business </li></ul><ul><li>No potential Alternative Minimum Tax (AMT) or accumulated earnings tax. </li></ul>
  13. 13. Disadvantages of Cross Purchase <ul><li>May require several policies </li></ul><ul><li>Owner may let policy lapse </li></ul><ul><li>Premiums are non-deductible </li></ul><ul><li>Individual may be in higher income tax bracket than corporation </li></ul>
  14. 14. Trusteed Arrangement <ul><li>Cross-Purchase plan for more than three owners. </li></ul><ul><li>Trustee purchases life insurance on each of the owners. </li></ul><ul><li>At death the trustee collects the insurance proceeds and purchases the business interest from the estate of the deceased shareholder. </li></ul>
  15. 15. The Dilemma <ul><li>Transfer for value </li></ul><ul><ul><li>It is unlikely that this type of cross-purchase avoids the transfer for value problem that arises after the first death. </li></ul></ul><ul><ul><li>The death of a shareholder would be construed as causing a transfer of the deceased shareholder’s beneficial interest. </li></ul></ul>
  16. 16. Partnership Arrangements <ul><li>Similar to trusteed cross-purchase plans </li></ul><ul><li>Shareholders form partnership instead of creating a trust. </li></ul><ul><li>Partnership purchases a policy on each owner. </li></ul><ul><li>Should avoid transfer for value problem. </li></ul>
  17. 17. Example <ul><li>Dick and Tom are equal partners in a chain of Backstairs Coffee shops in DC. The value of the shops is $5,000,000. </li></ul><ul><li>They want to ensure the success of the shops if something happens to them. </li></ul><ul><li>They are going to set up a cross purchase buy-sell arrangement. </li></ul>
  18. 18. How Does it work? <ul><li>Tom and Dick buy a $2,500,000 policy on each other. </li></ul><ul><li>Tom dies first. </li></ul><ul><li>Dick uses the death benefit proceeds to purchase the stock from Tom’s estate. </li></ul>
  19. 19. Here is How it Works Backstairs Coffee Shops $5,000,000 CNA Insurance Tom’s Interest/Estate Dick’s Interest Stock Purchase Price Premium on Dick’s Life Premium on Tom’s Life Proceeds from the policy on Tom’s Life
  20. 20. Entity Purchase Arrangement <ul><li>An arrangement between the business entity and its owners </li></ul><ul><li>Business agrees to redeem the interest of an owner in the case of death, disability, or retirement. </li></ul>
  21. 21. Funding an Entity Plan <ul><li>Business is the owner and beneficiary of the policy </li></ul><ul><li>Business pays the premiums and uses the death benefits to buy out its shareholders </li></ul>
  22. 22. The Tax Perspective <ul><li>An entity arrangement with a C-Corporation will not increase the basis of remaining shareholders’ stock. </li></ul><ul><li>At death the beneficiaries likely will not report a gain – because the deceased shareholder’s estate receives a step-up in basis. </li></ul><ul><li>Watch for estate tax developments that may take away basis step-up. </li></ul>
  23. 23. The Tax Perspective <ul><li>Redemption hopefully will be taxed as a sale rather than a dividend. (Watch for attribution issues.) </li></ul><ul><li>Taxation as a sale is beneficial because only the gain is subject to tax at the capital gains rate. </li></ul><ul><li>Since dividend and capital gain rates are now the same, presence or absence of basis will be important factor. </li></ul>
  24. 24. Advantages of Entity Plan <ul><li>Entity purchase plan is not complicated by multiple shareholders. </li></ul><ul><li>Corporate check, not personal. </li></ul><ul><li>Tax-efficient funding strategy. </li></ul><ul><li>May be structured to fix value for estate tax purposes. </li></ul>
  25. 25. The Disadvantages of Entity Plan <ul><li>The remaining owners will not receive a step-up in basis in their remaining shares when the entity redeems the interest. </li></ul><ul><li>In a pass through entity (S, LLC, Partnership) the remaining owners will receive a partial or total basis step-up </li></ul><ul><li>FASB 150 may cause financial statement distress </li></ul><ul><ul><ul><ul><li>Requires mandatory corporate redemption be reflected as liability </li></ul></ul></ul></ul>
  26. 26. The Disadvantages of Entity Plan <ul><li>Life insurance will be subject to the claims of corporate creditors. </li></ul><ul><li>State law may prohibit the sale if the business is insolvent or lacks capital. </li></ul><ul><li>Premium payments are not deductible. </li></ul><ul><li>Life Insurance received by a C-Corporation may cause a 15% Alternative Minimum Tax (AMT), if corporation has over $5 million in sales. </li></ul>
  27. 27. Example <ul><li>ABC, Inc. is a manufacturer of boating equipment located in California. It has four owners. </li></ul><ul><li>Its owners have agreed to enter into an entity buy-sell arrangement with ABC, Inc. </li></ul><ul><li>Its assets are $5,000,000 with $3,000,000 in liabilities for a net value of $2,000,000. </li></ul>
  28. 28. Here is How it Will Work <ul><li>ABC, Inc will purchase life insurance with a death benefit of $500,000 on each owner. </li></ul><ul><li>ABC, Inc. is the owner and beneficiary of each policy. </li></ul><ul><li>At the death of an owner, ABC, Inc. will redeem that deceased owner’s interest. </li></ul>
  29. 29. Here is How it Works ABC, Inc. $2,000,000 Insurance Co. Mary’s Estate Mary’s Death Benefit Premiums for Jane, Mary, Fred, and Paul Redemption Price Stock
  30. 30. Wait and See <ul><li>Owners wait until a shareholder’s death to determine the best way to effect the buy-sell agreement </li></ul><ul><li>Very Flexible </li></ul><ul><li>Gives owners the choice of using cross purchase or entity purchase arrangement </li></ul><ul><li>Funding decision must still be made at outset </li></ul>
  31. 31. Example <ul><li>Fun Times is a restaurant on Martha’s Vineyard. It was started by two college friends (Peter and Bill) and now has three locations. It is valued at $2,000,000. </li></ul><ul><li>They need a buy-sell arrangement, but do not want to commit to the ultimate purchase, preferring to wait until the first death to examine the situation. </li></ul>
  32. 32. Here is How it Works <ul><li>Peter and Bill purchase life insurance policies on each other. </li></ul><ul><li>Peter dies first </li></ul><ul><li>Fun Times has the first right of refusal on Peter’s shares. </li></ul><ul><li>If Fun Times does not purchase the shares, Bill must buy the shares. </li></ul><ul><li>If Bill wants Fun Times to make purchase, he contributes proceeds to Fun Times </li></ul>
  33. 33. Here is How it Works Fun Times Peter’s Estate Bill Insurance Company First Right Second Right Redemption Price Shares at Redemption Price
  34. 34. Funding Methods <ul><li>Life Insurance </li></ul><ul><li>Borrow Funds </li></ul><ul><li>Sinking Fund </li></ul><ul><li>Installment Purchase </li></ul><ul><li>Remember, a triggering event will often be something other than death. </li></ul>
  35. 35. Life Insurance <ul><li>Most common method. </li></ul><ul><li>Cost effective. </li></ul><ul><li>Predictable amount of cash available upon death. </li></ul><ul><li>Policy’s cash value may be enough to fund a buy-out prior to death. </li></ul><ul><li>Sometimes done on a split dollar basis. </li></ul>
  36. 36. Borrowing, Installment or Sinking Funds <ul><li>Borrowing or Installment </li></ul><ul><ul><li>May cause a strain on cash flow. </li></ul></ul><ul><ul><li>Future payments are dependent on success of business </li></ul></ul><ul><li>Sinking Fund </li></ul><ul><ul><li>May result in taxes on investments. </li></ul></ul><ul><ul><li>Retained earnings. </li></ul></ul>
  37. 37. Valuation Methodologies <ul><li>Specified Fixed Price </li></ul><ul><li>Book Value </li></ul><ul><li>Capitalization of Earnings </li></ul><ul><li>Formula </li></ul><ul><li>Appraisal </li></ul><ul><li>Cut Throat </li></ul><ul><li>Combination of methods </li></ul>
  38. 38. Fixed Price <ul><li>Periodically fix by arrangement </li></ul><ul><ul><li>Pros </li></ul></ul><ul><ul><ul><li>Simple </li></ul></ul></ul><ul><ul><li>Cons </li></ul></ul><ul><ul><ul><li>Parties often fail to adjust price for changes. </li></ul></ul></ul><ul><ul><ul><li>If not adjusted, unfair to selling shareholder. </li></ul></ul></ul><ul><ul><ul><li>IRS may disregard the actual selling price and attribute a higher value. </li></ul></ul></ul>
  39. 39. Book Value <ul><ul><li>Pros </li></ul></ul><ul><ul><ul><li>Simple </li></ul></ul></ul><ul><ul><li>Cons </li></ul></ul><ul><ul><ul><li>Seldom an accurate reflection of value </li></ul></ul></ul><ul><ul><ul><li>Reflects depreciated historic values </li></ul></ul></ul><ul><ul><ul><li>Ignores earnings potential </li></ul></ul></ul>
  40. 40. Capitalization of Earnings <ul><li>Value determined by multiplying earnings by capitalization factor. </li></ul><ul><ul><li>Pros </li></ul></ul><ul><ul><ul><li>Most effective if earnings remains constant. </li></ul></ul></ul><ul><ul><li>Cons </li></ul></ul><ul><ul><ul><li>Earnings can be manipulated . </li></ul></ul></ul>
  41. 41. Cut Throat <ul><li>Determined by the shareholders at the time of the sale. </li></ul><ul><ul><li>Pros </li></ul></ul><ul><ul><ul><li>Used in lifetime sales. </li></ul></ul></ul><ul><ul><li>Cons </li></ul></ul><ul><ul><ul><li>Often favors the shareholder with the deepest pockets. </li></ul></ul></ul>
  42. 42. Combination <ul><li>Formula method. </li></ul><ul><li>Usual sale is based upon book value and capitalization of earnings. </li></ul><ul><li>Pros </li></ul><ul><ul><li>Mitigates the disadvantages of the other techniques. </li></ul></ul>
  43. 43. The IRS’s View on Family Business Valuation <ul><li>In order for the valuation to be binding, there must be a bona fide business arrangement. </li></ul><ul><li>The agreement must fix a way to determine the price. </li></ul><ul><li>The terms must be comparable to an arms length transaction. </li></ul><ul><li>The arrangement must not be a device to transfer assets to family members at a discount. </li></ul>
  44. 44. Buy Sell Case Study <ul><li>How do you make sure every kid receives their fair share? </li></ul>
  45. 45. History of Fashion Plus <ul><li>Brothers Jeff and Tony opened a clothing store as a C corporation. </li></ul><ul><li>Jeff has four kids, two active in the business, and two not active. </li></ul><ul><li>Tony has two kids who are involved with other interests. </li></ul>
  46. 46. The Facts <ul><li>Jeff’s two kids are active in the day-to-day operations. </li></ul><ul><li>Tony’s kids are not interested in the business. </li></ul><ul><li>Jeff and Tony want to leave their interests (or the value thereof) to their respective kids. </li></ul>
  47. 47. The Problem <ul><li>In 1990, Jeff and Tony set up an entity purchase buy-sell arrangement. </li></ul><ul><li>In 1998, Jeff retired and they updated the buy-sell arrangement to include the active children. </li></ul><ul><li>The business is worth $2 million. </li></ul><ul><li>What do you think they did? </li></ul>
  48. 48. The Solution: Entity Buy-Sell Arrangement for Tony <ul><li>Fashion Plus will purchase a $1 million life insurance policy on Tony. </li></ul><ul><li>When Tony passes away, the life insurance proceeds will be used to buy his shares from his children. </li></ul><ul><li>Jeff and his family will continue to run the business. </li></ul>
  49. 49. Here is what it looks like Stock Fashion Plus Insurance Co. Tony’s Estate Jeff’s Estate Death Benefit Premiums (life of Tony) Redemption Price
  50. 50. The Solution: Cross Purchase Buy-Sell Arrangement for Jeff <ul><li>Jeff’s children will purchase a life policy on Jeff. ($1 million on Jeff and $1 million second to die on Jeff and Tony) </li></ul><ul><li>When Jeff passes away, the life insurance proceeds will be used by his children to buy his shares. </li></ul><ul><li>Jeff’s active children will continue to run the business. </li></ul><ul><li>If Jeff dies first, Tony will buy the individual policy on his life from the business. </li></ul>
  51. 51. Summary <ul><li>By setting up a combination Entity/ Cross Purchase Buy-Sell Arrangement, Jeff and Tony ensure the success of Fashion Plus for the next generations. </li></ul>
  52. 52. Summary <ul><li>“ A well-drafted and adequately funded buy-sell arrangement is an important piece of a business owner’s succession and estate plan. Without a buy-sell arrangement a business owner can lose much of the equity he worked a lifetime to create…with appropriate buy-sell planning, happy endings can be achieved.” </li></ul><ul><li>Randy Zipse </li></ul>
  53. 53. For More Information <ul><li>Please contact: </li></ul><ul><li>J. Garth Swartley, LUTCF, CSA </li></ul><ul><li>Vice President </li></ul><ul><li>Northeast Brokerage, Inc. </li></ul><ul><li>610-689-4073 </li></ul><ul><li>[email_address] </li></ul><ul><li>www.northeastbrokerage.com </li></ul>

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