|Business Continuation Planning in Closely Held Businesses
How life insurance and disability buy-out insurance fit in the equation.
October 20, 2011
The continuation of closely-held businesses should be planned for because there is no ready market for the transference of ownership and many do not have non-owner executives and managers. A central part of business continuation planning (BCP) involves the appropriate purchase of life insurance and disability buy-out insurance.
Business owners should have a strategic legally binding plan for the continuation or liquidation of their business in the event of an unexpected permanent disability or death of a partner otherwise its value could be greatly dissipated and the potential for conflict with the permanently disabled or deceased partner’s family greatly increases. Planning for retirement usually should not be part of a legally binding document because it is voluntary and negotiations with other partners about retirement should take place at the time it is being considered.
Sam and Pranab — The Early Years
Sam and Pranab are equal owners of an engineering consulting firm, which is a regular corporation. They employ five others, including two other engineers. They need to negotiate a buy-sell agreement. They will need to work with an attorney, insurance specialist and their accountant to assist them in determining the value of their company. The buy-sell agreement is important because it establishes the ground rules of the business transfer and establishes a price for this transfer. Further, a properly drafted buy-sell agreement will bind their families to the provisions they formalize in the agreement making it much less likely that trouble will arise after a permanent disability or death.
Sam and Pranab decide their business is worth $3 million, about half of which is goodwill. They understand that the adjusted book value (assets plus cumulative depreciation minus liabilities) is not a good reflection of how valuable the business is to them and are therefore encouraged to revise the value each year on an exhibit to their buy-sell agreement rather than to rely on a formula provided in the agreement.
Once the value has been determined, Sam and Pranab need to decide whether the agreement should be an entity or cross purchase. The entity purchase is an agreement each shareholder has with the corporation to redeem his stock in the event of permanent disability or death. The cross purchase is an agreement between the shareholders themselves. The major difference between the entity and cross purchase is the impact each type has on the surviving shareholder (also consideration needs to be given to the alternative minimum tax (AMT) for C corporations).
An example will illustrate this difference. Sam and Pranab have valued their business at $3 million, or $1.5 million each. They each own 50 percent of the stock and each has a $100,000 cost basis in their stock. They conclude an entity purchase agreement funded with life insurance their corporation owns. The corporation redeems Sam’s stock for $1.5 million when he dies. This transaction leaves Pranab owning all of the outstanding stock, but his cost basis remains at $100,000. If Pranab subsequently sells the company for $4 million, he will have a capital gain of $3.9 million. However, a cross-purchase arrangement would have Pranab owning the life insurance on Sam’s life and purchasing his stock directly thereby increasing Pranab’s cost basis by $1.5 million and decreasing his possible future capital-gain taxes by $1.5 million. Whether an entity or cross purchase is the better agreement is largely dependent how likely it is that the business will be saleable to outside owners. If it is very likely that the business can be sold as an ongoing business then a cross purchase is probably a better arrangement for Sam and Pranab to potentially increase the surviving shareholder’s cost basis. However if it is quite unlikely that their business will be sold as an ongoing business an entity purchase might be the better choice. With two shareholders of about the same age and health I recommend that when in doubt use the cross purchase approach.
Whether an entity or cross purchase is selected life insurance should be purchased to fund the purchase obligation in the event of the death of Sam or Pranab. For an entity purchase the life insurance is owned by and payable to the corporation. For a cross purchase a policy insuring Sam’s life is owned by and payable to Pranab and a policy insuring Pranab’s life is owned by and payable to Sam. Conventional universal life (not no lapse) with a specified death benefit plus the cash value is ideal for either an entity or cross purchase because of its flexibility since its premium can be treated as term insurance in years the company has cash flow problems and in normal years higher premium funding will cause the death benefits to increase which might coincide with the company’s value increasing. Tracking the company’s value is important to keep the life insurance funding in line with increasing values. If significant increases in business value were to occur, additional life insurance might have to be purchased to keep up. Typically, any business value in excess of life insurance proceeds will be paid, usually over five years to 10 years, to the deceased shareholder’s family at an agreed upon interest rate so keeping the life insurance funding up to date is important so the surviving shareholder’s out-of-pocket obligations are manageable.
If the buy-sell agreement provides that a permanently disabled shareholder’s stock is to be purchased disability buy-out (DBO) insurance should be purchased to fund this obligation. As is the case with life insurance the corporation under an entity purchase plan can own the DBO policies or Sam and Pranab can cross own them under a cross-purchase plan. A DBO policy will offer different waiting periods (usually one year or two years) and different pay-out alternatives (usually lump-sum to five years). As is the case with life insurance, a DBO policy is owned by and payable, for example, to Sam will increase his cost basis when Sam uses the DBO proceeds to buy Pranab stock following Pranab’s disability. A common mistake I see is business owners confusing disability income (DI) insurance with DBO. DI insures the disabled shareholder’s loss of income, while DBO just provides the funding to redeem his stock. Finally, before including permanent disability as a buy-out trigger funded with DBO thought has to be given to whether the shareholders really want this to occur. It is possible because of the business structure (S corporation, for example) and level of profits that shareholders would want to continue owning stock during a permanent disability and receive a share of the profits.
Often business owners don’t purchase DBO because of its expense. In that event, the buy-sell agreement might be silent as to how a permanent disability should be handled so the non-disabled owner isn’t obligated to an expensive stock redemption that can’t be afforded. In that case the partners will just have to make the best of it. Many business owners think that disability income insurance they have is covering a buy-out. It isn’t.
In an upcoming issue I will continue with several other business continuation case studies as a way of explaining some of the complexities encountered in business continuation planning.
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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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