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.