Peter Katt
Peter Katt
Business Continuation in Buy-Sell Planning

Two complicated scenarios revealed when younger shareholders are added to the mix.

November 17, 2011
by Peter Katt, CFP, LIC

Returning to buy-sell planning from my last column — crisp new businesses with relatively younger shareholders owning an equal number of shares are the prototype business continuation situation that can be planned for with few complications, but this is not the typical situation. The majority of business continuation cases I see have complicating factors that must be planned for.

Here are two common situations that are usually encountered.

Dave’s Construction Company (DCC)

Dave is 40 and has been in the construction business for 10 years. He owns 100 percent of DCC stock that has an adjusted book value of $3 million. Dave has reinvested most profits and has accumulated few investment assets outside DCC. None of his three children are old enough for him to know if they will eventually come into the business with him. DCC has one key employee, Hal, who is 35. Dave is concerned about what would happen to his family as well as DCC, if he died. A local insurance agent is trying to convince him to give Hal one percent of the stock and set up an entity buy-sell agreement with DCC to purchase his stock, leaving Hal with all of the outstanding stock. DCC would own a $3 million life-insurance policy on Dave to fund this obligation. Dave wants a second opinion on this recommendation.

The net result of the recommended buy-sell plan is to give a $3 million business to Hal, via DCCs (really Dave) purchase of life insurance and to have Dave’s family exchange $3 million in DCC’s stock for cash without otherwise adding any value to the estate. This is a great deal for Hal, but a horrible deal for Dave’s family.

Instead, Dave should consider purchasing a $3 million life insurance policy to be owned by and payable in an irrevocable trust with his wife and children as the beneficiaries of this trust. Then privately instruct only his attorney, accountant and wife in writing, to work closely with Hal (since he knows the market and other construction firms) in the event of Dave’s untimely death to begin immediate negotiations for the sale or liquidation of DCC with Hal receiving substantial compensation for this service. In doing so, Hal may be able to secure key employment with DCC’s successor owner, including the possibility of a minority-ownership interest.

What this does for Dave’s family is to secure the value of DCC in the form of life insurance in the irrevocable trust, plus the additional value that will probably come from the immediate sale or liquidation of DCC that might be close to the $3 million adjusted book value. By instructing his advisors and wife to move quickly to sell or liquidate DCC, with Hal’s full assistance, Dave has substantially increased the prospects of getting the maximum value for DCC with the greatest likelihood that DCC employees will still have their jobs because there is a definite and immediate plan in place to sell or liquidate DCC. For the same insurance costs Dave has potentially increased his estate by some $3 million for his family’s benefit rather than basically giving his company to Hal.

Dave might consider whole life or universal life for the purchase of the life insurance policy in the irrevocable trust.

While this planning is a good match for Dave’s current objectives it needs to be reviewed every few years to manage the performance of the life insurance policy properly, confirm Hal’s present key role and check whether one or more of Dave’s children might have entered the business.

Sam and Pranab — The Late Years

Sam and Pranab are co-owners of Engineering Consulting Associates (ECA). They instituted a buy-sell agreement funded life insurance 20 years ago. Sam now owns three universal-life policies totaling $2 million on Pranab’s life and vice versa. Recently their buy-sell perspectives have taken an interesting turn because Sam’s son John and Pranab’s daughter Rekha, both engineers, joined the firm as employees. Sam and Pranab agree that they would like these children to acquire their stock at their respective deaths. Buy-sell planning for the transference of stock within a shareholder’s family should be incorporated within each individual shareholders overall estate planning.

John is Sam’s only child so coordinating Sam’s buy-sell/estate planning does not have to take into account possible inheritance equalization among several children. Therefore, Sam will simply leave his stock to John via his will or revocable trust. What must be planned for is making sure there are enough invested assets to provide sufficient income for Sam’s wife if he dies before her, taking into account possible estate-tax obligations. Besides the $2 million worth of ECA stock, Sam has acquired $1.5 million in marketable securities and $1 million in two homes, for a total estate of $4.5 million.

It is recommended that the life-insurance policies insuring Sam’s life that Pranab owned and ends up an irrevocable trust for Sam’s wife’s benefit. Therefore, including the life insurance, Sam’s assets now total $6.5 million, of which $4.5 will be included in his estate. In addition to leaving all of the stock to John upon Sam’s death, Sam will also gift stock to John using annual exclusion gifts. The results of this planning could trigger an estate tax at Sam’s death with his wife surviving. Regardless of who dies first, the stock will go to John at Sam’s death and there should be sufficient assets to pay estate taxes and provide for Sam’s wife without encumbering the stock.

Planning for Pranab’s transfer of his ECA stock to his daughter Rekha is more complicated because the value of the stock is his largest asset and Pranab has two children who don’t work in the business and therefore should not receive ECA stock. Leaving such a large amount to Rekha causes inheritance equalization problems. This is because Pranab’s other assets total $2 million of which $1.5 million are in marketable securities and $500,000 in real estate assets. Pranab transfers the policies insuring him to a partnership between him and Rekha to avoid the transfer for value problem. Pranab has a minimal partnership interest. The partnership will purchase his ECA stock up to $2.0 million with the balance (if any) being distributed to Rekha. Pranab and the other children are the only beneficiaries of his estate to balance the inheritances as much as possible. Pranab also starts gifting stock to Rekha. This plan pivots from Sam’s and Pranab’s prior buy-sell arrangement to take into account children joining the business.

Look out for a final case study in upcoming column that involves a medical corporation, which will expose very common errors.

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Peter Katt, CFP, LIC, is a fee-only life insurance advisor since 1983, he has written insurance columns for AAII Journal and Journal of Financial Planning since 1991.

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* *DISCLOSURE: Readers should assume that all insurance advice mentioned in this column are the author’s and/or his firm’s unless otherwise noted and does not necessarily reflect the views of the AICPA or the AICPA Wealth Management Insider.