What’s a mother (or father) to do?
Their youngest son has worked alongside them in the family business through high school and college. Their other children took different career paths. The parents want to give less time to the business. The son wants to take on more responsibility.
So, should mom and dad transition the management and retain ownership, possibly for income purposes? If they transfer ownership as well, should it be as a gift or should the son buy the business? These are the issues that need to be addressed (with appropriate sensitivity to family dynamics) before recommendations are offered.
Consider this example. Dad started his industrial supply business several years ago. Today the firm has 27 employees, $2.5 million in annual sales and a fair market value of about $1 million. Dad turned 60 recently. Mom relinquished her bookkeeping duties a couple of years ago.
Dad wants to slow down but can’t now due to stiff competition. His youngest son, 30, is anxious for a greater role in the business, but dad isn’t quite ready to turn over the reins.
How does he keep his son interested and in position to take over the business in three to five years? What does dad do for his other two children if he just turns over the business to his youngest? What will mom and dad rely on for income if dad no longer has a part in the business?
A family meeting produces a major conclusion: Dad and mom don’t want to shortchange any of their children regarding their inheritance, especially with regard to dad’s business. Here are some alternatives they all can consider.
With the youngest son recently married and planning to start a family, dad can help with the son’s financial protection by paying for life and disability insurance as a bonus to the son. This is a simple and easy plan to administer and could be an incentive for the son to stay in the business.
If dad turns over the business to his son, the IRS may treat the transfer as a taxable gift. The business probably makes up a major share of dad’s total estate. There may not be an equal value among the other assets to pass on to his other two children.
In this situation, dad could purchase life insurance with a value comparable to that of the business and name his other children as beneficiaries. Since the business is an S corporation, dad can retain ownership after he retires and turns over management to his son.
This arrangement gives dad and mom income from the business’s profits to supplement their retirement. The son can buy life insurance on dad to provide cash for buying the business when dad dies.
Upon dad’s retirement, the son buys out dad with a note. The note provides dad and mom with an income during their retirement. The son takes out life insurance on himself and collaterally assigns it to dad to cover the balance of the note if he (the son) dies.
Dad retains ownership of the business following his retirement. The son takes over management of the business and buys enough life insurance on dad to allow him to buy out his siblings’ shares upon dad’s death. Since dad wants to treat all his children equally at his death, this arrangement gives the son sufficient funds to purchase his siblings’ business interests.
The types of life insurance purchased in each of these instances would be determined by the situation. For example, the son may prefer permanent life insurance, with dad paying premiums to the son.
Dad may want to consider permanent life insurance comparable in value to that of the business given to the son. The son may want term life insurance on himself to assign collaterally the policy to dad to cover the note. And he may want permanent life insurance on dad to buy out his siblings upon dad’s death.
Alternatively, the son might consider purchasing a survivorship policy on mom and dad to buy out his siblings. (This would make sense if the business were to pass to mom at dad’s death for continued income purposes.)
Client Needs Set the Course
This hypothetical scenario illustrates situations that may be encountered frequently in succession planning for small enterprises. The insurance solutions that will serve them best will most likely result from thorough consideration of your clients’ individual circumstances and, when appropriate, their family dynamics as well.
Jim McNamara, CLU, ChFC, REBC, LUTCF, is advanced markets specialist, advanced markets, at Mutual of Omaha, Omaha, Neb. You can e-mail him at firstname.lastname@example.org.