Planning For When Business Owners Retire

Buy-sell agreements are designed to facilitate the orderly transition of the ownership and management of a business. The typical triggering events are death, disability and retirement. But in selecting the structure of a buy-sell agreement, most of the attention is placed on what happens in the event of death or disability.

In many cases, however, business owners will survive to retirement. Therefore, the consequences of how a particular structure will work out at retirement must be considered as well.

Related to retirement is whether or not the remaining owners will be able to pay off the retiring owner. Any help they can get in that area will be appreciated. The same goes for the retiring owner. The business will likely be the source of capital for the buyout funds, so its financial life is important to the owner as well.

Life Insurance Funds The Agreement

Life insurance is the widely accepted way to fund a buy-sell agreement. While term insurance can be an inexpensive way to provide coverage, permanent life insurance has the additional value of being its own sinking fund. That is, the increasing cash values of permanent life insurance can, in certain circumstances, be useful at retirement. Permanent life insurance also can last indefinitely.

Lets compare and contrast 2 of the most common buy-sell strategiescross purchase and entity, or stock redemption planat both death and retirement, and see how permanent life insurance can be used in those differing circumstances.

Consider the following example: Assume Dan and Ben, 50/50 partners, founded a business several years ago, organized it as a corporation and elected C-corporation taxation. As with most small start-ups it was underfunded, as all the partners could come up with was $10,000 each. To get them over the hump, their wives had to go back to work for a couple years and to keep costs down their children came in to help with clerical office work. Dan and Ben worked hard and eventually developed an extremely successful business, conservatively worth $5,000,000.

Dan and Ben set up a cross purchase buy-sell agreement. They cross insured it, as is the typical approach, with Dan being owner and beneficiary of a policy on Bens life, and vice versa. They kept the insurance coverage up with the increasing value of the business. When Ben passed away unexpectedly in a bungee jumping accident (a hobby he took up after the life insurance had been issued!), Dan had the $2,500,000 death benefit to buy Bens stock.

After the purchase, Dans basis in the stock he owned was $2,510,000. Thats the sum of the $10,000 he originally contributed and the $2,500,000 he paid for Bens stock. When Dan sells the business for $10,000,000 at his retirement, his gain will be $7,490,000 ($10,000,000 2,510,000 = $7,490,000). At the current 15% maximum capital gains rate, that will save Dan $375,000.

This example illustrates one of the prime benefits of a cross purchase agreement, the “step up in basis” to the remaining owner when purchasing another owners interest at the other owners death or retirement.

If Dan and Ben had an entity purchase plan, the corporation would have bought Bens stock and it would have cost Dan more money in the future. When Dan subsequently sold out, his basis would have been only $10,000 and his gain would have been $9,990,000. That would have increased his gain by $2,500,000 and increased his capital gains tax cost by the $375,000 mentioned above. That would be the extra cost of having an entity buy-sell agreement.

Its important to note that another benefit to using life insurance to fund the buyout was that the purchase of Bens stock did not put any financial strain on the business. Finding and training Bens replacement may have caused a problemand should have been covered by key person indemnification insurancebut the purchase itself was fully funded.

Now lets look at what is more likely to have happenedBen lives and retires. Actually, Ben will retire to start another business. Having had a close call with bungee jumping, he takes up skydiving, still a thrill, but not as dangerous. He retires from this business to start up another, a skydiving school and flying service.

Aside from considering Bens new career, we need to make some further assumptions. Dan and Ben are the same age, and they started the business when they were 34. The insurance on each of their lives was $2,500,000, universal life, Option 1 (aka: Option Alevel death benefit), and the premiums were $22,100 annually. At the end of 20 years the death benefit is still $2,500,000 with a cash value of $745,000. Each policy has a basis of $442,000. Ben is retiring after 20 years with the business and Dan is going to carry it on indefinitely. We need to further assume that in the event of retirement or disability the buy-sell agreement calls for an installment payoff of quarterly payments at 5% over a period of 10 years.

In either situationcross purchase or entity structurethe sale of Bens stock at his retirement is a taxable transaction, a long-term capital gain. Therefore, the tax consequences to Ben will be the same, no matter which structure was chosen.

Upon Bens retirement there will be no need for him to own the policy on Dans life and vice versa. Therefore, they will trade the policies. That is a barter sale and a taxable transaction. Both policies are the same, so Ben is selling the policy on Dans life to Dan for $745,000. He paid $442,000 for that policy, so he is realizing a $303,000 gain. Taxed as ordinary income, the tax on the gain could be as high as $106,050 (35%, the top marginal rate in 2004).

Likewise, Dan is selling the policy on Bens life to Ben for $745,000, and hes paying for it with something that cost him $442,000so he, too, has a $303,000 gain. The tax result is that up to $212,100 of additional individual income tax will have to be paid.

After the policies have been sold back and forth there would still be the matter of buying Bens stock. The price is $2,500,000, to be paid in quarterly installments at 5% over the next 10 years. That makes the payment $79,804.

Good News: Transactions Are Exempt From Rules

There is some good news here. Since each policy is being transferred to the insured, they are exempt from the transfer-for-value rules. This does not save any income taxes at the time of the exchange of the contracts, but it does preserve the tax-free nature of the death benefit payable from the contract.

In addition, the life insurance now has served 2 purposes. First, it funded the buy-sell agreement for 20 years, providing financial protection against accident or death for Bens thrill seeking or an incautious step by Dan. Second, both Dan and Ben have $2,500,000 of life insurance. Thats life insurance that neither could get without being rated; Ben because of his hobby and occupation, and Dan because of the hypertension caused by worrying about Ben while Ben was engaging in his dangerous hobbies.

Aside from that, we can contrast the outcome under the cross purchase structure with what would have happened under an entity, or stock redemption, plan.

The corporation would have owned the policies. Bens policy would have been transferred to him as partial payment for his stock. That would have reduced the unpaid balance from $2,500,000 to $1,755,000, which would have reduced the quarterly payment to $56,022. That would put substantially less of a strain on the business. The tax on the gain is no different. The policies werent traded, so that taxable transaction disappears. The remaining life insurance contract still is owned by the corporation, meaning it will be there to be transferred to Dan at a later date, possibly as part of a liquidating distribution after Dan sells the business at his retirement.

Under the entity structure, at retirement, we used the life insurance in another wayto partially pay off the retiring owner. That allowed the life insurance to be used in a third way. In addition, using it as a down payment substantially reduced financial strain on the business, which resulted from the ongoing need to make the installment payments to Ben.

Ben, Dan, the employees, lenders, suppliers and customers, are all happier because the use of a buy-sell agreement provides a better chance the business will continue.

David K. Smucker, CPA, CLU, is an advanced markets consultant for Nationwide Financial, Columbus, Ohio. He can be reached at smucked@nationwide.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 20, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.