As an advisor to business owners, you help them identify a way to transition out of their business, when to sell and to whom, how to structure the sale and how to determine the purchase price. Transferring a business generally falls into one of two categories: (1) transfer the business itself or (2) transfer the financial benefits of the business.
Keeping it in the family
Many business owners are likely to see the business continuing in the hands of family members only and may not have thought about outside ownership. If there are family members, such as a son or daughter ready to take over, then the transition may be an easy one. The next owner should be someone who fits the position and is on the way to having all the skills necessary to take over the business.
In the second scenario, the business owner wants to exchange the business for financial benefits. The business interest may be sold to the remaining owner(s), a key employee or an outside party. The owner typically plans to use the sale proceeds to meet his or her retirement income needs or to provide for his or her family’s survivor income needs.
Once the business owner has decided what he or she would like to happen to the business and has a transition plan in mind, the next step is to put the plan in writing. This is accomplished using a buy-sell agreement, a legal contract for the future sale of a business. It is legally binding and sets the terms and conditions for the sale.
While there are several ways to structure a buy-sell agreement, this article will focus on a cross-purchase buy-sell with existing owners, funded with life insurance. Each owner purchases an insurance policy on the life of the other business owner with after-tax dollars; and each is both owner and beneficiary of the policy. At the death of the first business owner, the remaining owner uses the death benefit proceeds to buy out the deceased owner’s interest in the business. This is a case where a well-designed and funded agreement allows for the smooth transition of the business interest, with the deceased owners estate receiving a fair price for his or her share of the business.
But what happens when there are multiple owners? The number of policies needed to fully fund the agreement can be onerous. Each owner would need to purchase a policy on the life of each other owner. The formula for determining the number needed is “N x (N-1)” where “N” is the number of owners. For example, in a business with 3 owners, 6 policies would be needed (3 x 2). If there are 4 owners, 12 policies are needed.
Enter the trust