BUSINESS TRANSITION - By Anita Grossman
The result was chaos. Betty had no interest in running the firm, and no experience working in the business. She needed cash for her living expenses and asked Steve to buy her out. Because most of Steve’s assets were tied up in the business, he was short of cash. He and Betty were left with little choice but to sell the company on short notice for just a fraction of what it was worth.
How could this fictional disaster have been avoided? A buy-sell agreement and proper funding could have saved the business while providing needed income for Betty and her family. Buy-sell agreements lay out how ownership will change hands and how the transfer will be paid for in case of a co-owner’s death, disability or retirement. Typically, the agreement provides for the purchase of the departing shareholder’s stock by the surviving shareholders or the company itself.
A buy-sell agreement, properly funded with life insurance, may achieve several goals: avoiding liquidation of the business, facilitating an orderly continuation of the business, replacing lost business income for a deceased owner’s heirs, setting a purchase price that can fix the estate tax value of the decedent’s stock, and providing evidence of the firm’s stability to customers and creditors. Even a single-owner business can be protected by structuring the buy-sell so a key employee (or a group of employees), a competitor, a supplier or a customer is named as the buyer.
The ‘seven Ds’
A carefully crafted buy-sell is essential for a smooth transition of ownership upon the occurrence of any one of the following events:
1. Death of a shareholder. In the event of an owner’s death, the business can suffer a financial setback (key person loss). This problem can be compounded if the surviving shareholders must take on the deceased owner’s spouse as a partner. The spouse may have very little knowledge of the business but yet expect a salary and profits from the company. Harmonious transition of the business can be accomplished with a buy-sell agreement that is fully funded with life insurance.
2. Disability of a shareholder. While most buy-sells take an owner’s death into account, many ignore disability, which could be a more serious financial drain. In other cases, disability is poorly defined (if at all), not funded or underfunded in a buy-sell agreement. A disabled shareholder would expect his or her salary to continue, and would also expect to receive a share of profits. But in the case of a prolonged injury or illness, how long could the business keep paying? All of these cases, and what would happen if they occurred, should be outlined in the agreement. The terms should be a business decision based on previously agreed-upon parameters, not on emotions. And, of course, the disability agreement should be fully funded.
3. Departure of a shareholder. When a shareholder leaves, whether owing to retirement or for other reasons, his or her interest in the business should be purchased. The purchase price could be the same amount that the owner’s survivors would receive if he or she were to die. A lower purchase price might be set for early termination. For retirement planning, a life insurance policy can provide a death benefit; cash values can also be used as a retirement supplement.
4. Divorce of a shareholder. If the owner of a closely held business divorces, it is not unusual for the former spouse to end up with half the business interest. There should be a provision in the buy-sell that requires the former spouse to sell stock back to the corporation, the original shareholder or the other shareholders. The price should be at fair market value, however it is determined in the original agreement.
5. Deadlock. If equal owners have a major disagreement, the business may be unable to move forward or operate normally. In extreme cases, the business may have to be liquidated. A thorough buy-sell agreement would take this hypothetical circumstance into account.
6. Disagreement among minority and majority owners. If there is a major disagreement among unequal owners, a minority shareholder could be forced out of active employment. In that case, it would also probably make sense to purchase his or her interest. This possibility should be covered in the agreement.
7. Default. In most closely held corporations, the individual shareholders must personally guarantee corporate loans from banks or contribute payments to the bank or the business. There should be a provision stipulating that if a shareholder defaults, a buyout would be triggered for his or her interest.
The eighth D: Determination of value
The most important item in a buy-sell agreement concerns valuation of the business interest. It is advisable to engage a business valuation professional. In addition to setting a value for purposes of a buy-sell agreement, in the case of an owner’s death a proper valuation can be used to fix the value in the deceased’s estate for federal estate tax purposes. One of the requirements under federal tax law is that the price assigned to the property must be set at fair market value when the agreement is entered into.
Types of buy-sell agreements
There are three basic types of buy-sell arrangements. Life insurance can be used to fund all three.
• Cross-purchase agreement. In Wayne and Steve’s situation, each of them would buy—and be the owner and beneficiary of—a life insurance policy on the other. Upon Wayne’s death, Steve would receive the policy’s death benefit, which he would use to purchase Wayne’s shares from his estate. In turn, that cash payment would give Wayne’s family needed income to offset the loss of Wayne’s earnings.
Cross-purchase plans have several advantages. The surviving shareholder gets a “step up” in the income tax basis to the value at the date of death for the stock purchased. This could reduce income taxes, if the surviving shareholder later sells the stock. Also, with cross-purchase agreements, the insurance proceeds are not subject to the corporate alternative minimum tax (AMT), nor to the claims of corporate creditors. But these plans can be difficult to administer if there are many owners.
• Stock redemption agreement. In this case, Profitable Companies Inc. would buy and own insurance policies on the lives of Wayne and Steve. On Wayne’s death, the corporation would buy his stock with the insurance proceeds, which in this example would go to his estate for Betty’s benefit. Stock redemption plans may make sense if there are multiple owners of the corporation, if there are large differences in age or ownership levels among the owners, or if the corporation is in a lower tax bracket than the owners. Two potential drawbacks to these plans: the death proceeds received by the corporation may be subject to the corporate AMT, and the surviving shareholders do not get the benefit of an increase in the income tax basis of their shares when the corporation redeems the stock.
• ‘Wait and see’ agreement. Some decisions are best put off until a triggering event occurs. This type of buy-sell allows for that. For example, if a business owner is inclined to use a buy-sell agreement because of current circumstances but feels a stock redemption agreement might be more advantageous in the future, a “wait and see” might be a good solution.
Planning is essential
You may think that you and your partner can work out succession issues as they arise. But a partner’s death, disability or retirement usually creates different objectives for each party. A lack of foresight and planning in this regard could prevent the transmission of a business to the next generation.
Anita Grossman (anita.grossman@LFG.com) is a registered representative of Lincoln Financial Advisors, a broker/dealer, and offers investment advisory service through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor, in Cherry Hill, N.J.