Business succession plans and buy-sell agreements are vital for owners of a closely held business and, yet, often are not even addressed within a company’s documentation or operating agreement. According to PwC’s 2021 Family Business Survey, only 34% of family businesses have a documented and communicated continuity plan in place. Despite this, in a recent survey by Deloitte, 86% of business owners believe succession planning is an “urgent” and “important” priority, yet only 13% believe they do it well. The exiting of a business does not have to be difficult if the owners plan and prepare for their exits, whether on their own schedule or because of an unexpected event such as a death or disability.
Cedar Point Financial Services LLC can help closely held businesses plan for an orderly transition upon a triggering event such as the death, disability, retirement or withdrawal of any of the business’s shareholders, owners or business partners.
Putting a Buy-Sell Agreement in Place
A “best practice” for succession planning involves having an agreement in place among shareholders that gives either the shareholders or the company the right or obligation to purchase the interests of a shareholder at that shareholder’s death, disability, retirement, or resignation. A buy-sell agreement not only identifies triggering events but states valuation methodologies, payment terms, etc. Many businesses look to future cash flow as a way to fund a buy-sell strategy…but is that the most efficient method to purchase the interest in the case of a deceased or disabled owner?
Life insurance is often part of the solution for buy-sell plans triggered by death as it provides an immediate income tax-free source of capital when a business or shareholder needs it most. Proceeds received from life insurance may also provide estate liquidity to offset debt, expenses, and taxes. It may provide a valuable income stream for loved survivors. In addition, cash value life insurance can serve as a sinking fund from which to withdraw money to fund a buyout upon a triggering event.
When using life insurance to fund a buy-sell agreement, business owners generally choose between three types of plans:
- Cross-Purchase Plan
- Entity Redemption Plan
- Hybrid Plan
Cross-Purchase Plan
In a cross-purchase plan, each owner purchases a life insurance policy on the other owner(s). Then, when an owner dies, the remaining owner(s) use the payout from the life insurance policy to buy the deceased owner’s share of the business. The purchasing owner(s) receive(s) a full step-up in basis. As part of a cross-purchase plan, the deceased owner, or the owner’s estate if they die, is obligated to sell their interest to the company.
These arrangements are straight-forward if there are two or three owners but, as the number of owners increases, so does the complexity of the plan due to the number of policies required. One way to address this complexity is to have a trust or a partnership (such as an ‘Insurance LLC’) acquire the policies on the lives of each owner, with each owner having his or her pro rata ownership in the trust the same as the ownership in the business entity.
Cedar Point Financial Services LLC can help business owners and their advisors evaluate if a cross-purchase plan makes sense and how life insurance can optimally be positioned to fund succession contingencies.
Entity Redemption Plan
An entity, or stock, redemption plan is where each owner enters into an agreement with the business to sell their interest to the business upon a triggering event. The company then purchases a life insurance policy on the life of each owner. When an owner dies, his or her shares can be redeemed by the company using the policy’s income tax-free death benefit.
If an owner were to leave the business, the company can use the cash value from the policy to help purchase that owner’s interest. The company could also give the policy on the life of the departing owner to the owner as full or partial payment of the owner’s interest. The policy could then be used by the departing shareholder in estate or future income planning.
Under an entity redemption plan only one policy per owner is needed and the cash surrender value of the policy is recorded as a business asset. However, there is not an increase in basis for the surviving shareholder and, if family members are involved, IRC §318 may create special tax problems that should be considered and discussed with a tax professional.
Cedar Point FinancialServices LLC can help business owners and their advisors evaluate if an entity redemption plan makes sense and how life insurance can optimally be positioned to fund exit contingencies.
Hybrid Plan
A hybrid plan, also known as a “wait-and-see” plan, allows business owners to postpone the choice between a cross-purchase plan and an entity redemption plan until the occurrence of a triggering event. In a hybrid plan, both the business and the owners agree to purchase the interest of a departing owner. Usually, the business has the first option to buy the interest with the other owners having the second option to purchase the interest, or any remainder of it. Then, the business must buy any unpurchased interest of the departing owner.
Each of the individual owners and the entity are potential life insurance owners. The business has the greatest exposure since it has a binding obligation to purchase the interest if the two options are unexercised, or incompletely exercised.
Cedar Point Financial Services LLC can help business owners and their advisors evaluate if a hybrid plan makes sense and how life insurance can optimally be positioned to fund exit contingencies.
Protect Your Business and Your Interests
Rarely, does a shareholder in a company want to end up in business with the family of a deceased partner or anyone else not of their choosing. A well-structured succession plan reflected in a buy-sell agreement and funded with life insurance will protect the business and the interests of all the owners. At Cedar Point Financial Services LLC, we look forward to helping plan for a smooth transition that secures your company’s continuity.