The closely held business is often underserved when it comes to succession planning. This can be due to the lack of a clear successor, not understanding available options or the possible consequences of doing nothing.
Is there a plan that can be both financially attractive as well as potentially flexible enough to motivate action: a planning solution that not only can assist with providing the required funding regardless of when the succession need is triggered but also help with the intrinsic idiosyncratic challenges?
The one-way buy-sell is such a tool. Depending on the owner’s goals, it can be structured to maximize tax efficiency or to maintain total long-term control and can even allow for estate planning considerations. Broadly, there are two basic types of one-way buy-sell: the bonus structure features a current tax deduction and endorsement split-dollar provides the owner long-term control. Most importantly, each encourages participation because it provides tangible financial incentives to all parties.
The bonus structure is the most straightforward of the one-way buy-sell strategies and most readily employed in family situations where a member or members of the next generation are going to eventually assume control of the business. Premiums are advanced to the family member employee(s) as tax-deductible compensation to purchase life insurance coverage on the business owner.
The business can “gross up” the extra compensation to account for all taxes, making the transaction income tax neutral to the recipient(s), while being fully tax deductible to business. In addition, an indemnity-style long term care (LTC) rider, can be added so tax-free funds can be available for executing the agreement regardless if the buy-out is triggered by the business owner’s death or disability. Moreover, the equity in the life insurance contract can serve as a tax favored sinking fund that can provide the down payment on a lifetime sale.
The income tax-free death benefit that will be used to buy out either the deceased owner’s spouse or the deceased owner’s estate, establishes the new owner’s basis in the business. This essentially uses tax-free dollars to create what will be the tax-free return of basis portion of the proceeds from any future sale of the business.
Further, since not all closely held businesses are small businesses and may be large enough to create an estate tax challenge, this structure provides liquidity outside the deceased owner’s taxable estate that can be used by heirs to pay estate taxes. This effectively leverages business dollars to create funds for the heirs from life insurance held outside the estate in a tax-deductible manner, while preserving traditional estate planning techniques.
If the owner decides to dispose of the business during his or her lifetime, the employee typically has the right of first refusal under a buy-sell agreement’s terms and conditions. (Photo: Thinkstock)
The bonus one-way buy-sell can accomplish a great deal while cementing the legacy between generations in a family business; however, it is obviously geared toward those circumstances where all participants have an inherent, vested interest due to their lineage.
Alternatively, what if more control is desired by the business owner over the ultimate funds used to execute the agreement? If the situation involves a key employee from outside the family who will likely take over, the business may consider funding the buyout plan with an endorsement split-dollar.
When “control” becomes more important than “tax deduction,” the business owner can personally own the life insurance policy and endorse a portion of the death benefit to the key employee. The key employee will have to recognize the economic benefit associated with the amount of tax-free death benefit to which he or she is entitled.
This is measured by either annual term rates published in IRS Table 2001 or the issuing carrier’s alternative rates (if available) times the share of the death benefit (DB) due to the key employee. This is akin to rent, and is paid to the policy owner who recognizes it as income.
To provide detail to this discussion, we will now focus on specific samples illustrating the practical application of these concepts.
Ron Brown, age 50, is the sole owner of Custom Car Concepts, LLC (CCC) – a 10-year-old company that repairs, restores, and maintains high-end luxury cars. The business is very profitable. CCC has six full-time employees, including Greg Brown, age 38, who is Ron’s nephew and most dependable worker.
Lately, Ron has been thinking about what would happen to the business if he were no longer involved. He realizes that Mary, his wife, could not sustain the company for very long. He also feels that it would be difficult for Mary to sell the business for its full value.
Ron believes this because from time to time, he has floated “trial balloons” about his business being “on the block” and got no takers. He and Mary have no children, and there are no immediate family members that could immediately step into his shoes to keep the business afloat. Ron’s CPA believes the business is worth $1 million based on the business’ generated annual income.
Of all Ron’s employees, Ron believes that Greg is the candidate most likely to successfully operate and actually own the business. Ron realizes that Greg’s current financial situation is such that he neither has enough savings nor the ability to borrow the money needed to purchase the business outright. Ron needs some help.
The bonus structure is the most straightforward of the one-way buy-sell strategies and most readily employed in family situations where a member or members of the next generation are going to eventually assume control of the business. (Source: Crump Life Insurance Services)
A one-way buy-sell agreement, which Ron and Greg decide to execute, typically includes the following terms and conditions:
The owner’s spouse or estate agrees, in the event of the owner’s death, to sell the entire interest in the business to the employee (who is often a family member).
The employee agrees to purchase the business subject to the terms and conditions of the agreement, using the funding provided by the life insurance, whether it is triggered by death, disability (the rider) or retirement (the policy’s cash value).
The owner agrees that he or she will not sell, assign, convey, encumber or otherwise dispose of the business or of any asset of business, except as allowed in the agreement.
If the owner decides to dispose of the business during his or her lifetime, the employee has the right of first refusal.
The bonus solution — After establishing and ratifying the buy-sell agreement, several things take place. Greg purchases a life insurance policy on Ron’s life with a $1 million death benefit (the amount equal to the value of CCC as set forth in the agreement). CCC establishes a bonus plan for Greg wherein CCC agrees to pay the premiums for the life insurance policy on Ron’s life. The premiums are deductible to CCC because they will appear on Greg’s annual tax notice as additional compensation.
Since it is not Ron’s intention to create an additional tax burden for Greg, CCC agrees to use a “double” or “gross-up” bonus for Greg: CCC pays Greg an additional bonus equal to all of the income taxes associated with the bonus of the premium. Doing so creates a larger deduction for CCC and makes the transaction income tax neutral to Greg.
What happens if Greg leaves CCC? What if Greg becomes disabled or dies before Ron? What if Ron decides to terminate Greg?
Greg, as owner of the policy (or his executor), could sell the policy for its fair market value to either Ron (the insured), or to CCC (of which Ron is the 100 percent owner). Either transfer qualifies as an exception to the transfer for value rules under IRC Sec. 101(a)(2)(B), thus preserving the income tax-exempt status of the policy’s death benefit.