Editor’s note: Steve Parrish travels the country working with hundreds of business owners to solve their problems and better prepare them for their financial future. Pete Leo works from the home office at Principal Financial Group, primarily with producers, advisors and business owners, performing reviews of buy-sell agreements, suggesting plan design changes and working with technical tax aspects of buy-sell planning. Pete recently addressed the Iowa State Bar Association on buy-sell reviews. What follows is a conversation between Steve and Pete on the importance of exit planning, business valuation and buy-sell reviews.
Steve Parrish: In the past year, you’ve been involved with many informal business valuations and buy-sell reviews. Can you provide background on what you’re seeing?
Pete Leo: In 2012, our area provided about 1,300 informal business valuations and reviewed around 160 buy-sell agreements. As you might imagine, the private businesses we see come in all shapes and sizes, from a dog-walking service to a provider of secret hardware for the military.
Parrish: Businesses have a lot going on at any one time, and a buy-sell agreement has implications beyond just good governance. What are some of the primary areas you look at when reviewing a buy-sell agreement?
Leo: A lot of the issues I focus on deal with the valuation method being used by the agreement — how it is determined, how it is reflected and the tax consequences that derive from the valuation. The valuation process in most agreements often fails this simple, two-step filter for a business owner: one, am I comfortable with the amount my family will receive if I die? And two, am I comfortable paying this same amount to the estate of a deceased co-owner for his or her interest in the business?
Parrish: Are there other valuation checkpoints?
Leo: Yes. For example, a key tax issue is valuation for federal estate tax purposes. Generally, fair market value (FMV) is the required goal for estate tax purposes. FMV equals the price at which a willing seller and willing buyer agree, with neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts. Special considerations come into play in setting the fair market value of a closely held, family business. Generally, a desired outcome is that the agreement and the IRS concur on the business interest’s value.
Parrish: I know you take a thorough look at the agreements to see how they handle life insurance matters. What are some of the issues you focus on?
Leo: First, we look at life insurance owned by the business. It’s important to consider the impact on company value of key person life insurance (where the company is the owner, beneficiary and premium payer). Then, one considers the impact on company value of life insurance death proceeds payable to the company for buy-sell redemption purposes. The proceeds may be includable in the company’s value on the same basis as key person death proceeds. However, with proper agreement structuring, life insurance death proceeds may be kept out of a company’s value. And keep in mind that life insurance death proceeds are only income tax free to an employer if the employer has complied with IRC Section 101(j). Financial advisors can be particularly helpful in alerting the drafting attorney to these requirements.
Parrish: Many times life insurance funding a buy-sell agreement is not actually owned by the business. What are the general tax considerations when the insurance is being held outside of the company?
Leo: Cross-owned life insurance funding a cross-purchase buy-sell plan design generally results in exclusion of death proceeds from the estate of the insured. A key tax aspect of cross-purchase plans is that the purchaser gets an increase in his or her cost basis in the business equal to the purchase price. This is helpful in reducing capital gains taxes upon a subsequent sale of the business interest.
Parrish: Agreeing on the value of the business is one thing, but reflecting it in the actual buy-sell agreement adds a layer of complexity. What are some of the ways you see buy-sell agreements reflecting the value to be used when a triggering event occurs, and what are some of the macro issues with the approach being used?
- Book value. It is not uncommon to see the value stated in the agreement as the “book value.” As a general rule, book value, without appropriate adjustments, is not an acceptable method of determining a profitable company’s value for tax purposes. Good buy-sell agreements should typically expand beyond this often simplistic approach.
- Agreed value or stated value approach. With this valuation approach, it is important to keep the value updated, and it may be a good idea to have a backup approach in place.
- Appraisal method. This approach, sometimes used as a backup method, has the advantage of a current and independent view by a knowledgeable party. Obviously the expense of this approach can be an issue. However, a major disadvantage is not knowing the value of the company prior to the occurrence of a triggering event. This can inhibit proper planning for funding the agreement.
- Formula valuation approach. While this may seem the best way to keep the value in the document flexible, there are some hidden traps that need to be attended to in the buy-sell agreement. For example, where a formula valuation is employed by the agreement and company-owned life insurance policies are present with the company listed as beneficiary, it is important for the agreement to be clear that life insurance death proceeds are not to be considered as cash or cash equivalents for purposes of the valuation formula.
- Purchase price directly linked to life insurance. The purchase price equals the greater of life insurance death proceeds or the agreement value. Alternatively, the purchase price may be defined as the exact face amount of life insurance protection owned by the company on the deceased business owner. Drafting attorneys should consider avoiding this method for determining value. Using the amount of life insurance death proceeds as a potential measure of a deceased owner’s interest is inconsistent with foundational IRS valuation guidelines.
- Mutual consent. This is determined by reaching agreement among the parties. For obvious reasons, this method is a dangerous approach to be taken and should generally be avoided.
Parrish: Is there any one overarching observation you can pass on to financial advisors concerning the provisions in buy-sell agreements?
Leo: A lot of buy-sell agreements are lacking in capturing the various events that typically trigger execution of the agreement. Some of the agreements only refer to death. Some include disability but don’t provide a definition.
Financial advisors can be instrumental in working with the client, the client’s tax advisor, and the client’s attorney in assuring that all possible triggers be considered. Where appropriate, they should be reflected in the buy-sell agreement. In many cases, it’s more likely that a party to the buy-sell agreement will retire or leave the company before a death or disability occurs. Events like divorce or insolvency can disrupt the workings of the business. A thorough review of the triggers, and the appropriate amounts of insurance to cover these contingencies, is the key to a successful buy-sell agreement.
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