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?