We cannot stress the importance of using life insurance to fund a buy-sell agreement or to provide business protection via key person insurance enough. In the following article we will attempt to provide some basic beneficial scenarios of life insurance on the life of a business owner.
Family Owned Business Succession Planning with Life Insurance
Many times the business will be the decedent’s primary asset. A fair devise to family members would be to give each of the decedent’s children an equal share of the business. The problem this can create is some kids are better suited for running the business than others. The business owner does not want to give equal voting rights to all the children. One option would be to transfer ownership interests in the form of nonvoting and voting interests. The kids that will not run the business have an equal share but no voting rights.
You could also choose to have the child who desires to take over the family business buy out his or her other siblings. However, coming up with the required money can be very difficult, if not impossible.
One option is to leave the business to the child that shows an interest and acumen for the family business. At the same time, take out a life insurance policy on the life of the parent, naming the other child’s siblings as beneficiaries. The life insurance proceeds would need to be large enough to compensate for the other children not receiving a share of the business.
A second option would be to set up a buy-sell agreement between the parent business owner and the child that is interested in taking over the family business. The parent and the child each take out a life insurance policy, naming the one another as the beneficiary. This has two advantages.
First, if the parent dies, the child has enough money to buy out the other children, or at least supply a down payment on the business.
Second, assuming the child is a vital employee, if the child should predecease his or her parent, the parent can use the proceeds to hire a replacement or to provide funds as the parent considers selling the company.
What type of buy-sell agreement life insurance should be used?
While there are many different types of life insurance policies, all life insurance typically falls under two main categories: permanent and term. The pros and cons of term life insurance vs. whole life insurance to fund buy sell agreements come down to two primary factors: time and cost.
Time vs. Cost
When deciding on whether to choose term or permanent coverage to fund a buy sell agreement, both time and cost have to be weighed. Should you desire to have a policy that lasts no matter how long it is needed, permanent life insurance would be ideal. However, permanent coverage comes with a higher premium than term life insurance, which makes permanent coverage not the ideal choice for everyone.
One solution is to purchase a term life insurance policy with a conversion option. The business and owners can save a valuable resource (liquid cash), but if needed, the policy can be converted to permanent coverage down the road, when cash flow has grown.
Buy Sell Agreement Valuation
Valuing the business can be done in various ways. Two of my favorite methods for valuing a business are book value or arbitration.
With arbitration, the buy-sell agreement includes provisions that a third party arbiter or mediator will value the company’s shares. But beware when using this approach. You will need to be specific on how “value” is determined, as perceived value is not always the actual Company’s value.
Book value uses a formula to determine the Company’s worth. Generally, the company’s assets are considered, minus any liabilities. The below provisions is a sample from a buy-sell agreement using the company’s book value.
The purchase price to be paid for the shares subject to this Agreement shall be 115 percent of their book value determined as of the end of the fiscal quarter preceding the month in which the event requiring determination of the purchase price occurs. The Corporation’s book value shall be equal to the excess of the book value of the total assets of the Corporation, including any proceeds of insurance policies/excluding the proceeds of any insurance policies owned by the Corporation on the lives of its shareholders, over the book value of the Corporation’s total liabilities, excluding the Corporation’s liability under this Agreement to purchase the shares for which the purchase price is being measured, based on the Corporation’s books and records.
The Corporation’s book value shall be determined in accordance with the accrual method of accounting and in accordance with generally accepted accounting principles applied on a basis consistent with those previously applied by the Corporation.
You might want to include some additional provisions, such as the following:
- All accrued and properly accruable taxes and assessments shall be deducted as liabilities.
- All normal fiscal year-end accruals and deferrals (including depreciation and income taxes) shall be prorated over the fiscal year.
- All inventory shall be valued at cost or market value, whichever is lower.
- All real property, leasehold improvements, machinery, furniture, fixtures, and equipment shall be valued at the valuation appearing on the Corporation’s books and records as adjusted for depreciation.
- The Corporation’s book value shall include the amount of any cash surrender value of any insurance policies owned by the Corporation insuring the life of any person.
- Each account payable shall be valued at its face amount.
- Each account receivable shall be valued at its face amount less a reasonable reserve for bad debts.
Buy Sell Agreement Triggers
Different events will trigger the requirement to buy or sell. These events are known as buyout triggers. Normally, events such as disability, retirement, and death. Divorce may also be a buyout trigger where a married couple are business partners.
If the business owners are going through a divorce, life insurance for a divorce decree or settlement should be considered.
Life insurance offers a great way to protect those you love as well as protect the business you spent your lifetime building. If you do not have life insurance please give us a call today to see what we can do for you.