Of all the questions we ask our business clients, few are as predictably answered as the following. Financial representative: “If your business co-owner died, how would you feel about being in business with your co-owner’s spouse?” Client: “I have no interest whatsoever in being in business with my business co-owner’s spouse.” Then I ask, “How does your current corporate agreement read in the event that either one of you becomes sick or injured, or dies?” And again the answer is, typically, “I think there’s a provision for it, but I have no idea how it reads.” This reality underscores the importance of business succession planning and, in particular, the buy-sell agreement.

 First Right of Refusal

 Most of the time, the buy-sell provision in standard corporate, LLC or ownership agreements is a “first right of refusal” provision; that is, it gives the surviving owner the “first right” to purchase the deceased owner’s share of the business. What this really means is that the deceased owner’s estate can’t sell it to someone other than the surviving owner without giving the surviving owner the first option to buy.

Typically the buying and selling in standard agreements is not mandatory. This can be detrimental from both perspectives. If the surviving spouse inherits the deceased owner’s interest, the surviving business owner is in business with the surviving spouse automatically. Not only may this not be what is intended, but in situations where a professional license is involved (medical, tax or legal practice), it may not even be possible. An unlicensed individual cannot own these types of entities.

What if the deceased owner’s spouse is not interested in selling? If the business is growing, it may be worth more in the near future than it is today, and the surviving spouse (and his/her attorney?) may not want to sell. Additionally, if the business is a closely held service company (think any business with “firm” in the name, law, accounting, venture, consulting, etc.), its valuation is typically one to two times gross revenue. In a small firm, the annual income lost by the business owner’s death can’t be replicated by the cash received via the buy-out. This could motivate the surviving spouse to not sell his/her interest.

Taking it a step further, what if a business is laden with debt or has large long-term lease obligations? The deceased owner’s spouse may be inheriting a liability.

Needless to say, a lot is at stake, and it is advantageous to discuss the disposition of the business before catastrophic events occur in order to ensure the most orderly and desired reorganization.  

 Let’s Look at a Case Study for a “Typical” Client

Elliot and Michael own a small advertising agency with annual gross revenue of $1 million. Elliot and Michael each draw $250,000 per year and the remaining $500,000 covers the other employees’ salaries and business overhead. Michael dies and his wife Hope inherits his share. Elliot and Hope don’t like each other, and we have a problem. Their agreement is “first right of refusal.” Hope decides she wants to be in the advertising business. Elliot is forced to work with Hope or start a new business without her (which would require time and money, and so is best avoided, if possible). Neither of the above options is good for Hope or Elliot. What if Hope didn’t want to do advertising and she tells Elliot to buy her out? Elliot shows her the agreement, which says that the business’s value is 1.5 x revenue. This puts the total value of the company at $1.5 million and Hope’s share at $750,000. Hope is living on Michael’s income of $250,000 per year, which is a lot more than the interest she would earn investing the $750,000. So Hope is motivated not to sell, and again, this is bad for both Hope and Elliot.

 Buying and Selling Should be Mandatory

There are two very simple solutions here. First, have the client’s attorney put “teeth” in the buy-sell agreement. The deceased owner’s estate must sell, and the surviving owner must buy. Every-one agrees in advance on the formula to determine the valuation (not a bad idea to have the spouses involved in this conversation so that there are no surprises), and the insurance agent makes certain all spouses are properly insured so dying doesn’t create a financial hardship that motivates adverse behavior from anyone.

Fund the Agreement

The second part of the solution is the agreement’s funding. The challenge is that most businesses are generally not liquid in an amount equal to 50 percent of their total value. If the surviving business owner could not afford to buy the deceased or disabled owner’s interest with the cash on hand, he would have to look elsewhere for the money. In theory, the business could borrow the money. But often in a situation where one of two business owners dies, it’s difficult to get additional lines of credit for the purpose we described. Michael was the “business guy” and Elliot was the “creative guy.” The bank liked them together but is worried about either of them as a solo act. Furthermore, when a business borrows to fund the buyout, not only does it end up paying the principal equal to half the value of the business, but it also pays the interest on the principal. Even in today’s low-interest environment, this is expensive and may compromise the business’s ability to borrow to finance company growth.

Using Insurance to Fund the Agreement

 As an alternative, one can fund a buy-sell agreement with two different types of insurance products. One product can fund the agreement in the event of a disability and one product can fund the agreement in the event of a death. As a practical matter, the funding in the event of death is generally easier to underwrite and is a much simpler product line to assist the client with. A disability is more likely to occur than a death prior to retirement. As such, disability buyout insurance can be a more complicated product than life insurance to get underwritten for the same purpose. That doesn’t diminish its importance, however. This is in addition to the added medical underwriting issues of disability products in general. A high percentage of my clients opt to handle disability buyout funding via noninsured alternatives. But all of our business-owner clients have both individual disability coverage and group disability coverage, giving the business greater cash flow (from the savings of not having to pay the owner’s salary) to fund the disability buyout when an owner becomes disabled. Funded buy-sell agreements create an orderly and predictable outcome during a very difficult time for all par-ties involved; the surviving owner of the business ends up controlling the business, and the deceased owner of the business ends up providing cash to his family equal to the value of his interest in the business.

 There are several different ways to structure a buy-sell agreement funded by life insurance. Below are the most common:

 [1] cross-purchase buy-sell

The first is a cross-purchase agreement that involves each owner purchasing a policy on the other owner or owners. This approach has the advantage of creating a step-up in basis for the purchasing owner to the fair market value of the stock or ownership interest that is purchased. If the surviving owner later sells the business, the tax liability will likely be lower as a result of the higher basis. However, this type of arrangement is challenging if there are more than three owners, as everyone owns a policy on everyone else. The number of policies is determined by this formula: n*(n-1), where “n” is the number of owners. Three owners require six policies. Four owners require 12 policies, etc.

  [ 2 ] entity buy-sell

This approach involves the business entity itself purchasing the policy. With C-corps there is no step-up in basis, but with S-corps, LLCs and partnerships, a limited step-up may be possible. You will be working closely with a client’s attorney in these types of cases, and the attorney and/ or CPA will determine the actual tax consequence of the arrangement chosen. From the insurance perspective, “entity buy-sell agreements” can be advantageous in that they require fewer policies, and if there are pricing differences in the policies involved, it is more easily handled if the entity is doing the premium paying. Age and health can create a situation where policies may have very different premium amounts for two business owners. Since cross-purchased policies are personally owned, this can be more cumbersome to make equitable from a cost-sharing standpoint. Premium can be bonused and perhaps double bonused to account for the tax as well. If the entity is paying, it is handled at the business level, not the individual level.

[ 3 ] term or perm

Permanent life insurance coverage is ideal for situations where ownership will be held until death, such as in the case of a family business. Additionally, permanent life insurance coverage can create a sinking fund for a buyout during the owners’ lifetime, or as a vehicle in which to save money for future business opportunities. Term insurance, especially level-premium policies where the duration is based on the owner’s estimated retirement age, are also a very effective way to fund the buyout.

Lastly, remember that in virtually all circumstances, life insurance is not tax deductible, even if the business entity owns it and is paying for it.

 Brad Elman, CLU, is a principal at Nine Dots Benefits inLos Altos, Ca-lif. His practice focuses on employee and executive benefits for closely held service companies. He is an 18-year MDRT member with eight Court of the Table qualifications.


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