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The business succession plan: Do your clients have one?

By Jill Perlin

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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? 

Related: Are you asking the right succession planning questions?

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. 

Related: Retirement planning for small business owners

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: 

  1. an entity purchase agreement/stock redemption agreement or; 

  2. a cross-purchase agreement.   

Related: SMB owners rethinking retirement benefits to retain, recruit

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. 

Related: Millennial small biz owners: More prepared in 4 key areas

When establishing a business succession plan that includes a buy-sell agreement, it’s important to be mindful of potential gift tax, estate tax and business valuation issues. (Photo: Thinkstock)

Split-dollar arrangements 

Another aspect to buy-sell agreements is a split dollar arrangement.  As in other types of buy-sell agreements, life insurance is often a funding vehicle.   

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.  

Generally, the employer will pay all of the premiums and will own all of the policy cash value. This agreement is executed separately and independently of the basic buy-sell agreement relating to the purchase and sale of the owner’s business interest.  

At the owner’s death, the employer receives death proceeds equal to the greater of its premium payment or the policy cash value. The employee receives remaining death proceeds, income tax-free.  

The employee’s death proceeds are then used toward the purchase of the business interest. The key employee is the original applicant and owner of the life insurance policy.  

The employer’s interest in the policy cash value is secured by a collateral assignment form signed by the policyowner (the key employee). The collateral assignment provides the employer with full access to the policy cash values.  

In a split-dollar arrangement, the employee will be taxed each year on the term insurance value of the death benefit the employee would receive if the owner died during the calendar year. Although the owner’s share of the policy premium is a nondeductible expense, the corporation’s cash value interest can be fully recovered by the owner’s family at his or her eventual death.  

In addition, they will also receive the employee’s share of the policy death proceeds when the deceased owner’s business interest is purchased from his or her estate. 

Important considerations 

When establishing a business succession plan that includes a buy-sell agreement, it’s important to be mindful of potential gift tax, estate tax and business valuation issues.  The implementation of a buy-sell agreement and the required sale under the agreement should not be taxable gifts where the transaction is a bona fide business arrangement and adequate consideration is given to all parties through their mutual promises.   

The IRS often scrutinizes family transactions and will use the valuation rules found in IRC §2703 to ignore valuations that provide for a sale at less than the business’ fair market value.  However, if certain criteria are met, the IRS will honor valuations established in the agreement.  It’s generally best to work with a qualified tax advisor on these complex issues. 

Related: 

Business succession planning: The day after disaster strikes

A case study in life insurance as a succession planning tool

Succession Planning: Just be SMART

The COLI market is making a comeback