While small or closely held businesses represent more than 99.7 percent of all U.S. companies, only 36 percent of small business owners have, in the event of their death, a business continuation plan that protects family members and business partners. As financial advisors, you likely have clients who are small business owners.
You may have done some personal financial planning with them. Have you talked to them about the future of their business?
Small business owners have a lot to consider in running their businesses, from managing day-to-day operations to growing revenues. However, neglecting a plan for the future can create financial hardships for remaining owners or partners, as well as the owner’s family. This is particularly important if the business is the major source of a family income, a personal investment vehicle, and a major portion of the owner’s estate.
Buy-sell agreements as a solution
A common approach to business succession planning to is enter into a buy-sell agreement with one or more key employees. Under this arrangement, the owner commits her estate to sell the business interest to the key employees upon her death. There are generally four ways to fund a buy-sell arrangement:
From cash flow
Through the use of a sinking fund
Borrowing the money
With life insurance proceeds.
Economic downturns or other market conditions beyond the owner’s control may reduce cash flow and make it difficult, or impossible, for the business to support the buyout. Death, disability, or an owner’s withdrawal can occur without notice and sooner than expected.
The loss of a key employee may impair the creditworthiness of both the business and the remaining owners. Banks may be reluctant to lend money to the business or the remaining owners.
Interest costs may also be excessive. Life insurance is often the most practical and economic solution, as it helps provide the needed funds at the death of the owner. In addition, if cash value life insurance is used, the cash value accumulates on an income tax-deferred basis and can be accessed through withdrawals and/or loans to fund the down payment for lifetime buyouts.
Split-dollar arrangements are often used in instances where the key employee does not have sufficient funds to meet premium payments and the business owner has the desire and ability to assist the employee. (Photo: Thinkstock)
Structuring a buy-sell agreement
A buy-sell agreement is generally structured in one of two ways:
an entity purchase agreement/stock redemption agreement or;
a cross-purchase agreement.
In an entity purchase format, the buy-sell agreement is between the business and the owners. The business promises to buy back the ownership interest of the deceased (or disabled or retired) owner.
The business bears the cost of financing the agreement. When the buy-sell agreement is funded with life insurance, the business is the owner, beneficiary and premium payer on the lives of its owners.
A cross-purchase agreement is between the co-owners of the business. The remaining/surviving owners are contractually obligated to purchase the interest of a deceased (or disabled or retired) owner.
The business is not a party to the agreement. The financing obligation is shifted to the remaining/surviving owners. When the buy-sell agreement is funded with life insurance, each owner is the owner, beneficiary and premium payer of an appropriate amount of life insurance on the other owners.