1. Fund a Buy-Sell Agreement With Your Partners
You are a closely-held business owner, and you have just put a buy-sell agreement together. It will require the corporation (if it is a stock redemption agreement) or the remaining shareholders (in the case of a cross-purchase agreement) to buy the stock of a deceased, retiring, or permanently disabled stockholder. It would require the estate of the stockholder to sell under a formula devised while all parties are alive and well.
Now the key question – how to fund the agreement? There are generally five accepted solutions:
-Personal funds of the buyers: most successful business people do not keep large sums of liquid assets on hand. Their money is working in their business.
-Sinking fund in the business: such a fund would be inadequate if death is premature and the time of need is uncertain. Plus, a corporation may develop an accumulated earnings tax problem.
-Borrowed funds: Loss of a key person (owner) may impair the credit availability of the business as well as the other partners/shareholders. Interest costs may be excessive, and may be non-deductible to surviving partners or shareholders.
-Installment payments to heirs: The business could fail and the payments could stop. Principal and interest payments may be just too burdensome.
Life insurance owned by the buyer: This is what risk management is – 1. complete financing guaranteed from the beginning; 2. Proceeds free from income tax; 3. Cash values, if present, can be used for buyout at retirement or disability; 4. It is far and away the most economical (think heavily discounted dollars); and 5. The company’s credit position is strengthened.
2. Plan for Your Family’s Business Succession
Let’s start with how a lack of planning can affect a deceased business owner’s family:
Lack of credit – heirs might not be able to obtain the loans necessary to continue operation of the business in the same manner
Lack of liquidity – heirs might not have the assets needed to buy the business or even pay the transfer taxes if the business is bequeathed or gifted
Inheritance disputes -equalizing inheritance among multiple heirs can be a challenge if the business asset base is highly illiquid
Cash flow – a surviving spouse and other dependents may need the income generated by the business to maintain the same standard of living
Questions to Consider:
- Do you want your business to continue at your death, disability, or retirement?
- Is most of the wealth tied into your business considered illiquid?
- Do you want to keep the business in the family?
- Do you want heirs who work outside the family business to receive an equitable distribution of your estate?
- Do you want to establish a fair market value for your business?
If you recognize that the establishment of a plan is necessary, here’s what we’d do next:
- Obtain a business valuation from a firm recognized by the IRS
- Properly title the affected assets
- Structure the agreement
- Fund the agreement- What is your preference: Cash? Borrow? Sinking fund? Installment payments? Life Insurance? Of these options, only life insurance represents a pennies-on-the-dollar, potentially income and estate tax-free alternative.
3. Cover Your Key Persons for Pennies on the Dollar
Valuing key employees is important, but it is usually also quite difficult. What is the exact monetary value a key employee or owner brings to your business? This figure is commonly based on a loan amount the company is acquiring or perhaps another arbitrary amount an investor has calculated.
While the amount of coverage should address the specific needs of the company, the insurance company’s primary goal in valuing a key person for life and disability insurance is to determine the realistic loss associated with the death or disability of such employee. Often businesses request an amount of key man insurance that is not reasonable or even available from life and disability insurance companies. The insurance amount must be justifiable – not simply equal to the amount of funds being borrowed from a lender.
To determine the amount of key person insurance that will meet the needs of both the business and the insurance provider, there are various valuation methods. These valuation methods are listed in detail as follows:
The multiples of income method. The simplest and most common method used to determine the value of a key executive or business owner is the multiples of income method. Insurance companies typically base the amount of key person insurance needed on a multiple of five to seven times the employee’s current salary compensation and benefits. For example, using a multiple of five,
$1,000,000 would be the amount of insurance needed for a key person with a salary package totaling $200,000. Of course, as with all valuation methods, the specifics of the situation could determine a higher or lower figure.
The replacement cost method. With this valuation method, the estimated cost of replacing the key employee determines the amount of key man insurance needed. To calculate this replacement cost, not only is salary a factor, but also the expenses needed to recruit, hire, train and bring the new employee up to the same level as the former one must be included. Additionally, there should be added to this the expected decline in revenue following the death or disability of a key person.
The contributions to earnings method. The percentage contribution the key employee adds to the company’s bottom line profit is the basis of the contributions to earnings method. For instance, a small business may have one top salesperson that is contributing the bulk of the company’s sales, thereby generating a major portion of the company’s revenue. To use the contributions to earnings method, the actual value of that portion of the company’s yearly profits would be multiplied by the number of years required to sufficiently train one or more replacement employees.
4. Supplement Your Personal Retirement With The Same Tax Advantages of a Roth IRA
Most of our customers are familiar with the concept of a Roth IRA as a strategic funding idea for supplemental retirement income. Interestingly, many of the same customers who want to participate in a Roth IRA are ineligible due to income levels that exceed the limits imposed. What if there existed a plan that could provide the same tax benefits as a Roth IRA, without the restriction or limitations?
Life Insurance, for all the criticism it takes for the associated expenses and “die-to-collect” benefit theme, does have one distinct characteristic: you cannot beat the tax treatment. In general, and if structured properly, most anything that comes out of a life insurance policy, either at the death of the insured or during the insured’s life, comes out income tax free. If you stay within the guidelines and commit to a funding strategy, a case can be made that the back-end tax-free distributions are worth more than an up-front deduction. That is why Roth IRAs have flourished in the first place.
Any form of permanent life insurance is afforded the same tax treatment. First-in, first-out followed by properly structured policy loans can lead to tax-free distributions. Whole life, traditional universal life, indexed universal life, market-based universal life, all are eligible but all must adhere to the same rules. There is an old saying that “you know a concept is good when the IRS puts restrictions on it.” That is why for every dollar of contribution, based on age and gender of the insured, a minimum dollar of death benefit must be purchased. It also means that in theory, there is no dollar limit (keeping the death benefit ratio in mind) of contribution.
We have a dedicated partner who specializes in life insurance for business owners and access to the best rated carriers and pricing. If you have any questions about life insurance for business owners, would like us to show you strategies specific to your business, or would like to receive a quote, contact us at info@commonfinancialsense.com
