Business Continuity and Succession Planning for the Sole Trader
Buy Sell Planning Mark Simon
1. Buy-Sell Planning Transferring Your Business Ownership Presented by: Mark L. Simon Financial Services Professional California Insurance License No. 0E41454
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8. Don’t ignore the issues, or you’ll be sure to have a problem .
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12. Cross Purchase Insurance Co.. A B’s 100 shares $250,000 Estate 100 shares $250,000 100 shares $250,000 A B premiums premiums $250,000 death proceeds B
13. Stock Redemption 100 shares $300,000 Ins. Co. premiums ABC, Inc. 300 shares outstanding Valuation: $900,000 A’s stock is retired by the corporation $300,000 death proceeds 100 shares $300,000 100 shares $300,000 A B C death proceeds
15. Business Valuation Methods Per share price or total dollar amount based on one of these methods Book Value Agreed Formula Capitalized Earnings Agreed Value Appraised Value
19. Bank Loan Tip: Dollar-for-dollar, a bank loan is usually the most expensive funding option. Advantages Disadvantages Buys the business time Interest added to price Avoids using current dollars Business or owners may not qualify for a loan Interest payments may be deductible Default risk Interest rate risk
20. Sinking Fund Tip: If death or disability occurs in the early years, the sinking fund will be inadequately funded. Advantages Disadvantages If fully funded, provides a lump sum Timing is impossible to predict Only alternative if owners are uninsurable and loans unavailable Accumulating large amounts of cash is difficult Accumulated with after tax dollars High opportunity cost
21. Installment Payments Tip: The risk of default on installment payments increases as the length of the installment period increases. Advantages Disadvantages Business transfers between family members Interest is added to buyout price Repayment terms may be favorable Default risk Interest payments may be deductible Heirs may need a lump sum Inflation risk
22. Life Insurance Tip: Subject to insurability, life insurance is often the most affordable funding alternative. Advantages Disadvantages Self-completing Requires insurability Income tax-free death benefits Non-deductible premium payments Tax-deferred cash accumulation Policy cash values may trigger the alternative minimum tax for large C corporations Tax-advantaged Access to cash values Strengthens company’s credit
28. Probability of at Least One Long-Term Disability Source: Based on 1985 CIDA, Male, Classes 1 and 2 (4A/3A equivalent), 90-day waiting period. Prior to Age 65 Tip: Disability insurance and permanent (cash value) life insurance often fund disability buyouts.
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30. Plan now for the successful future of your business. Take the Next Step Today Tomorrow
Editor's Notes
As a business owner, you have special areas of interest with regard to fringe benefit planning.
What do you think would happen to your business if you suddenly died or became disabled? What would your reaction be if your business partner suddenly died or became disabled? Buy-sell planning is an effective way to provide for an orderly change of ownership when a business owner dies or becomes disabled.
Typically, there are three events which can trigger a need for a buy-sell plan: business owner's death, disability or retirement. A buy-sell agreement provides a plan for transfer of a business among the various business owners at the time of any of these events.
Why should you care about buy-sell planning? Because if you don't make preparations for the successful continuity of your business, its value may be gone. The best time to think about a buy-sell agreement is while the business is a going concern. Once the business reaches the liquidation phase (such as after the death of an owner), its value most likely will drop drastically. And once the business is gone, there is no value left!
What issues need to be addressed by the business owners in a buy-sell agreement? Well, most business owners want top dollar for their share of the business, prompt settlement of their estate, fixed estate tax value, and relief to their family from business worries.
The business partners are looking for different things. They’re generally interested in getting full control of the business as soon as possible for a fair price. Also, the surviving owners are going to want to avoid any interference from the heirs. Furthermore, they want a smooth and prompt transfer so as not to interrupt the flow of business or the business’ credit.
In the event of your death, your family would most likely need to sell your business interest as quickly as possible for a fair price. They would also benefit from minimizing income and capital gains taxes – taxes normally associated with the sale of a business. Under a buy-sell agreement triggered at death, the value of your business passes through your estate and receives an increase (referred to as a “step up”) in cost basis equal to the fair market value at the time of your death. This means that your heirs would not have any taxable gain after the buyout.
Don't ignore the issues of buy-sell planning. Lack of planning may put your family in an awkward position with respect to your business partners. In the event of death, your family won't have you to help with negotiations. A buy-sell agreement favorable to all parties can be most easily and fairly drafted prior to a crisis.
There are many advantages to having a buy-sell agreement. Proper planning can guarantee both a buyer and a fair price for the business, thereby providing for an orderly transfer of the business – and money for owners or heirs free from capital gains or income taxes. Also, a buy-sell agreement, if structured properly, can provide a binding value of the business for federal estate taxes. And last, but not least, proper planning provides for certainty – certainty that things will go the way you planned.
Everyone wins with buy-sell planning. As business owner, you will have peace of mind knowing that your family will be provided for financially, creditors will be assured that the business will remain viable, suppliers and key customers will not be tempted to go elsewhere and employees will feel safe knowing that a business succession plan is in place.
The right type of buy-sell agreement for you and your business will depend on several factors. The most common types of buy-sell agreements are the cross purchase and the stock redemption. Cross Purchase: an agreement between the individual shareholders in which shareholders purchase an ownership interest from a co-shareholder’s estate (in the event of death) or directly from a co-shareholder (in the event of disability). Typically, to fund the buy-sell agreement, each owner would buy an insurance policy on the life of each co-shareholder. The key point to remember with a cross-purchase plan is that the agreement is between the individual shareholders. Stock Redemption: an agreement between the business and the shareholders. At the death or disability of a shareholder, the corporation purchases the shareholder’s stock. To fund a typical stock redemption agreement, a business purchases and owns an insurance policy of the life of each shareholder. The key point to remember with stock redemption plans is that the agreement is between the business and the shareholders. Regardless of which type of buy-sell you select, the key is to make sure you fund it.
Let’s look at an example using life insurance to fund a cross-purchase buy-sell agreement. Let’s assume that A and B are equal owners of a business worth $500,000. A owns a $250,000 policy on B. B owns a $250,000 policy on A. In our example, B dies. Since A owns an insurance policy on B’s life, A will receive $250,000 of proceeds from the insurance company. A uses these income tax-free dollars to buy B’s interest in the business from B’s estate. A is now 100% owner of the business. Meanwhile, B’s heirs have received full value for B's business interest free from both capital gains and income taxes.
Let's shift gears for a moment and examine the second type of buy-sell agreement: the stock redemption. In this variation, it’s the corporation that buys the insurance policies on the lives of the shareholders, in this case, three life insurance policies – one insuring each owner. Let’s assume that the business is worth $900,000 and that the three shareholders are equal owners, and each of the owners holds 100 shares. If we assume that A is the first to die, what happens to A’s stock? The broken lines represent dollars and interests transferred at A's death. After A's death, the corporation has 100 outstanding shares worth $300,000. Shareholders B and C each still own 100 shares, but now that interest represents one-half of the corporation, not one-third as was the case before A's death. In deciding which type of buy-sell agreement is best for you and your business, there are many factors that need to be considered. I won’t go into any more details at this time, but would be happy to discuss your specific needs with you at a later date.
You need to determine the value of your business in order to determine a fair purchase price. There are many technical valuation formulas to use, but often, the best measure of the value of your business is what amount you would sell the business for today to a willing buyer – its “fair market value.”
Some business owners struggle with determining a fair market value for your business. While there is no “black-and-white” set rule for business valuation, there are several methods that you might find helpful. Buy-sells agreements are usually based either on a total dollar amount or per share price based on one of these formulas (or a variation thereof). 1 BOOK VALUE: Modifications to book value are often made depending on the type of business, the particular industry it is in or for countless other reasons (include/exclude accounts receivable, include goodwill, etc...) There are many combinations of the book value method. 2 APPRAISED VALUE: The business owners need to establish the standards for selecting an appraiser or appraisers and the methods the appraisers must follow. The is the most expensive but usually the most accurate method. 3 AGREED DOLLAR VALUE: This is the most simple method, but is often inaccurate. The owners simply agree on a buyout price. If this method is used, this price needs to be reviewed at least annually. 4 CAPITALIZATION OF EARNINGS: This method calculates average earnings over a five-year period, multiplied by an agreed upon capitalization factor (usually between 1-15). This method is common for service businesses with few tangible assets. High risk business = low multiplier. Low risk business = high multiplier. 5 AGREED FORMULA: This method usually involves a combination of book value and capitalization of earnings plus an additional amount for goodwill.
Many business owners realize the importance of adopting a buy-sell agreement, and do so, but fail to follow-through by making provisions for funding. An agreement obligating you to buy your partner's business interest at his or her death will be a big burden on you if you don't take the steps now to make sure that funding will be available when needed. I would be glad to provide you or your attorney with a sample copy of a buy-sell agreement. We have specimen buy-sell agreements available to assist you and your attorney in drafting an agreement. (To access sample agreements visit the Advanced Sales Library at www.ohionational.com.)
There are several alternatives available for funding a buy-sell agreement. Owners could use personal funds, obtain a bank loan, establish a sinking fund, make installment payments to the heirs of the deceased shareholder or purchase life insurance. Let’s take a closer look at the funding choices.
One option is for buyers to use personal funds to complete the buyout. This option is unrealistic for most business owners. Most successful business owners do not keep large sums of cash on hand. Instead, they prefer to have their money working within their businesses.
Obtaining a bank loan after the death or disability of an owner tends to be a “last resort” choice for owners who fail to plan ahead. Loans do have some advantages (listed above). Interest payments may be deductible for certain businesses using a stock redemption buy-sell. The rules are somewhat technical and require the assistance of a tax specialist.
Some business owners try to accumulate a sinking fund to provide the lump sum needed to complete the buyout. It might be the only alternative available if the owners are uninsurable and/or loans are unavailable. With sinking funds, timing is a major hurdle. Since death and disability are impossible to predict, how can owners be certain that their sinking fund will be fully funded in time? What if death or disability happens in the early years? Will the sinking fund be complete? Probably not!
Some family business owners consider the option of setting up an installment sale with periodic payments being made to heirs of the deceased owner. Installment sales are similar to bank loans with heirs serving as the bank – collecting periodic payments of principal plus interest (typically over a 5-10 year term). Like bank loans, interest payments may be tax deductible. Since the loan is usually between family members, repayment terms and conditions may be more favorable than a bank loan. Installment sales come with many costs. Interest is added to the buyout price. Default risk is especially important because if the business defaults on an installment sales , the heirs will lose out on all future payments. Also, heirs may prefer (or need) a lump sum payment as opposed to waiting 5-10 years to receive the entire buyout price. Moreover, inflation erodes the purchasing power of future installment payments. As time goes by, the value of each payment is diminished by the prevailing inflation rate.
Life insurance can be a very reliable funding vehicle for buy-sell agreements. A life insurance policy is designed to provide proceeds at the exact time they’re needed – at the business owner's death. Policy proceeds are typically free from income tax. Cash values of policies can be accessed if a buyout is desired at retirement or disability of an owner. Depending on the insured’s age and health, life insurance is often the most economical method of providing coverage while at the same time strengthening a company’s credit position. Insurance is not for everyone. Due to poor health and/or advanced age, business owners might not qualify for insurance coverage. Premium payments are nondeductible. Finally, there is a risk that policy cash values and death benefits may trigger the alternative minimum tax (AMT) for large C corporations. Check with your tax specialist to see if the AMT might apply in your case.
Life insurance is usually the most affordable funding vehicle for buy-sell agreements. For example, let’s assume two male partners own a business valued at $1,000,000. They are each 50% owners and enter a buy-sell agreement with a buyout price of $500,000 each. They are age 45 and in good health (rated as “preferred nonsmokers,” Ohio National’s second best rating class). This example depicts the cost after ten years, per dollar of buyout price, for Virtus Value, Ohio National’s fixed universal life insurance policy with an interest crediting rate of 5.75% versus other funding alternatives. This example depicts the sinking fund growing at 7% after-tax and that 8% annual interest payments for the bank loan and installment sale are nondeductible expenses. This example also assumes business earnings are taxed at 35% and can be reinvested earning 8% annually. After ten years, the cost-on-the-dollar for insurance is significantly less than the other funding alternatives. Life insurance offers a combination of affordability, flexibility and tax-free death benefits making it the “cost-on-the-dollar” winner in most cases. Factors such as age and health impact the cost effectiveness and availability of insurance coverage.
What type of insurance should you use to fund your buy-sell? Term life insurance is an affordable alternative for short-term needs (such as a buy-sell agreement designed to last for less than 10 years) or where a newer business does not have enough cash flow to support permanent life insurance policies. Make sure your policy is fully convertible to give you maximum flexibility. Many owners decide to convert their term insurance to a permanent policy once their business begins to mature and cash flow increases.
Most buy-sell agreements should use permanent life insurance. After all, nearly all buy-sell agreements are designed to stay in effect for many years. You need a permanent life insurance policy to fit a permanent plan. Additionally, permanent life insurance policies allow you to accumulate cash values on a tax-deferred basis – cash that you can access to help fund a retirement or disability buyout.
As your business continues to grow, you need to make sure your buy-sell funding keeps pace. By regularly updating coverage (either through using the increasing death benefit option on universal life insurance policies or purchasing additional coverage), you will ensure that your buy-sell agreement is adequately funded.
Most business owners understand the need for a buy-sell agreement in the event of death. Many, however, do not appreciate the need for a disability buy-sell plan. The disability of a business owner can have a serious financial effect on the ongoing operations of the business. Without a disability buyout in place, a disabled business owner would continue to take his or her share of the profits – without being able to do any work. How many months would you want to do all of the work, but not be entitled to all of the profits?
Source: Based on 1985 CIDA, Male, Classes 1 and 2 (4A / 3A equivalent), 90-day waiting period. For example, a group of three business owners aged 45 have a 60% chance of one of them suffering a long-term disability (lasting 90 days or longer) prior to age 65. I would be glad to show you how disability income and permanent life insurance can fit, affordably, into your buy-sell plan.
As a business owner, you need to be thinking about your retirement. Most business owners would like to enjoy the fruits of their labor when they reach retirement age. A properly structured buy-sell agreement provides for a retirement buyout (to take place when the owner reaches a stated age). Life insurance can help provide funds to complete a retirement buyout. When your buy-sell is funded with a permanent (cash value) life insurance policy, the accumulated cash values can be accessed in a tax-advantaged manner and used to fund a lifetime retirement sale.
Given all these factors, it’s clear to see that, without a funded buy-sell agreement, nobody may have their objectives satisfied. Any way you look at it, a funded buy-sell agreement is a win-win proposition.
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