If you own a business, odds are the business represents a sizable portion of your estate. Therefore, planning for the orderly disposition of the business is an important planning consideration.
The most basic element of the plan involves the use of a buy-sell agreement. It is astounding how many business owners do not have a buy-sell agreement. Even more amazing is the numbers who have one, but have no method to fund it. Let's take a look at the rationale behind a funded buy-sell agreement.
Creates a Market
Most businesses are closely held. A person can't call their stockbroker and buy shares in the business. Essentially, there is no market for the business.
If the business is a sole proprietorship or one-man or one-woman corporation, who is going to buy the business when the owner dies? In rare cases, a family member may be able to step in and successfully continue the business. Most of the time, the businesses simply closes its doors.
If the business owner is a partner or minority shareholder in a corporation, where is the financial motivation for the other owners to buy a minority interest? A buy-sell agreement among the person's partners, or one involving one or more key employees for the sole owner, creates a market for the business.
Avoids a New Partnership With the Heirs
In my experience, there is no quicker way to get a male business owner's attention with respect to business succession planning than to ask two questions.
"Do you and your partner have a buy-sell agreement?"
"If your partner died, would you like to be in business with his wife?"
When a partner dies, and the dust settles, generally one of two things happens. The wife calls up her husband's partner and asks where her paycheck has been for the last month. The partner has to explain that her husband's salary was a result of his active participation in the business, not tied simply to the fact that he owned stock in the business.
The second possibility is the wife, who has no experience or participation in the business, takes over her husband's position.
A buy-sell agreement avoids both of these scenarios.
Sets the Price
Assuming buyers surface, what is the value of the deceased owner's interest? If the seller is the deceased owner's family, they want as much as they can get. The remaining partners want to pay as little as possible. Oftentimes, the dollar amount is far apart.
By setting a price that everyone is happy with while living, there is no haggling over price at death. In addition, this "pegs" the value of the business for estate tax purposes. In the absence of an agreement, the estate lists a value on the estate tax return, if one is required. The IRS often comes back with their valuation opinion: a much higher amount. What ensues is a back and forth argument, involving attorney's fees and stress. Some of these cases have dragged on for as much as ten years.
Converts an Illiquid Asset to Cash
A properly funded buy-sell agreement instantly converts bricks, mortar and steel into cash. This provides funds for the heirs to pay obligations and taxes. Cash can be invested to generate an income; cash is easily divided among heirs.
Funded With Life Insurance
Assuming that a buy-sell agreement has been drafted, the next question becomes, "Where will the funds come from for the obligation now mandated by the buy-sell agreement?" There are three typical choices.
1. Pay cash. This is only an academic choice. Most businesses don't have cash in these amounts laying around.
2. Buy out over time. If the business interest is worth 500,000, the arrangement is to pay, for example, 50,000 plus interest over 10 years. Negotiations could be tough. The family wants their money as quickly as possible; the remaining owners want to string it out for as long as possible.
This option is expensive. It requires the survivors to pay principal plus interest. The payments put a mortgage on future earnings and have to go through the tax wringer. The result is paying much more than a dollar for each dollar of business interest purchased.
3. Fund the agreement with life insurance. This is the "discounted dollar" method. Money is available immediately to fund the agreement, and the total premiums on the policy will come nowhere near the amount received.
If you own a business and do not have a buy-sell agreement in effect, call your life insurance agent, attorney and accountant. Set up a meeting, come up with a value, have an agreement drafted, and fund it with life insurance. You have probably spent a lifetime putting your business together. Now allocate a couple of hours toward keeping it together for your heirs and circumventing a myriad of problems.
Robert D. Cavanaugh, CLU is a 36-year financial and estate planning veteran and author of the free newsletter, "The Estate Preservation Advisor". For cutting-edge, easy-to-understand financial planning resources and techniques to increase your income, reduce taxes and preserve your estate and to claim the free video, "How to Sell Your Life Insurance Policy for More than the Cash Value", go to http://theestatepreservationadvisor.com/rd/subscribe.htm