Insurance Foresight: Paving your road to retirement.
In my last article, I focused on how to protect the current assets of a company. But you must also protect your future assets if you want to live your dream.
Whether your business is a sole proprietorship, a partnership or a corporation, its future is interlocked with your personal and family goals for retirement. Just as you need to create a personal will in the event of your death, your business needs a will or a succession plan to answer the “what ifs” of death, disability and retirement.
Without a plan in place, a business will begin to die upon the death or disability of its owner. Trying to sell a business whose owner just died is like trying to sell a house that is on fire. The value of the company rapidly decreases at the very moment your heirs are looking for help to pay outstanding debts, estate taxes, funeral costs, etc. Your clients begin to allocate ongoing operations to other firms in the area. Competitors have no need to purchase your ongoing work when they can get it for free. Heirs are left with high-tech equipment, employees and debt. Your equipment will be sold at huge discounts to give your heirs the cash needed to pay for their expenses and to unload the burden of dealing with this issue, which may seem minor compared to their other problems.
Without an informed person at the helm, employees lose faith in the business. It’s time to wake up if you dream that your top employee will run into the burning building to save the business and your heirs. Pour yourself a cup of coffee, and let’s consider what your hero would need to save the day:
- A professional license. He or she must be registered in order to legally perform the survey work.
- Money. This can come in a few different forms, including cash reserves, personal loans and company loans. However, be aware that many would-be heroes have their own family expenses and aren’t saving money to purchase your business. At the time of the owner’s death, personal loans can be hard to arrange since creditors may shy away from someone whose salary is now uncertain. And as for company loans, creditors will not look favorably on a business that did not have a proper plan in place to fund the death/disability of the owner. They will also have a lack of faith in your customers since some may move on after the loss of the key person.
- The ability to perform two jobs. The employee needs to be able to function as the owner and still perform the job he or she was performing prior to the loss of the key person until a replacement can be found. This is a difficult scenario and is often complicated by stress, overwork and illness at this time.
- A realization that the company cannot afford an increase in his or her salary. Taking over doesn’t necessarily translate to higher wages at this point because the company must pay off the heirs of the deceased owner.
- An understanding of how to operate the business.
The majority of firms without a plan in place lose all of their employees and all of their work in progress while leaving the owner’s heirs with the work of sorting out what’s left over. To add to the heirs’ burden, the IRS will affix its own value to your business interest for federal estate tax. This value may be subject to as much as a 55-percent estate tax rate--not to mention your state estate tax. Paying for your unplanned departure could wipe out your entire estate.
Securing Your Future
Ready for the good news and a fresh cup of coffee? A business succession plan will:
- Relieve your heirs of the burden to liquidate assets in order to pay death taxes and other costs.
- Provide your heirs with a predetermined fair price for your interest in the business.
- Protect the business from uninvolved shareholders who may now want a say in how things are done, which could alter the business and affect its success.
- Minimize conflicts with the IRS on established value for estate tax purposes.
- Provide stability for employees, customers and creditors.
The Buy-Sell Plan
Many firms get stuck trying to peg a value for the business. This value can be ascertained using many different methods, such as approximating a fair market value, applying a formula or predetermining a price that the parties consent to. The important item to note is that the value can be changed, so pegging a value should not stall the progress of the succession plan.
The buy-sell agreement can be structured in two ways: “stock redemption” or “cross purchase.” A stock redemption plan allows the business to buy the interest of the deceased partner. In this agreement, the business is party to the contract. In a stock redemption plan, the surviving shareholder does not receive a step-up in his or her basis for the value of the decedent’s interest in the business. The cross purchase allows for a step-up in tax basis. The parties to this type of contract are the individuals who buy the shares of the deceased. Your CPA should guide you through the pros and cons of each method from a tax perspective. Your financial planner and insurance broker can also add their perspectives on funding considerations. The American way is to buy first and figure out “How are we going to pay for this?” later. Unfortunately, not many business heirs take credit cards. So it is best to set a plan in place that will allow the successors to afford the business. Paying for the business can be accomplished in several different ways:
- Invest in a sinking fund. These funds are accumulated over time and earmarked for purchasing the business. One of the downsides to this is that the funds do not have sufficient time to grow in the case of premature death or disability. Corporations that try to use this payment method may also have to deal with the issue of accumulated earnings tax.
- Borrow from a lender. The lender can be a bank, another entity, a group of investors, a family member, etc. Note that the loss of a key person may impair the credit worthiness of the business and its partners. If credit is available, the interest cost may be expensive and may not be deductible.
- Pay the seller by installment. In this instance, the seller acts as creditor to the business. The seller must decide if he or she wishes to be dependent upon the business without having a hand in management. Keep in mind that since the business is now subject to the efforts of a new person at the helm, it may not provide the same success.
- Purchase life and disability insurance. This can be an ideal method for funding the buy-sell agreement. Premiums are predictable and payable over time, and the cost of life premiums will not affect the working capital or credit of the purchaser. Upon the death of a partner, heirs receive cash from the life insurance proceeds in exchange for ownership. This allows for a prompt settlement by the heirs of estate and inheritance tax while also permitting the new and/or remaining owners to run the business without the interference of the heirs. Death benefits are also generally free from federal income tax. The downside would be that you pay the premiums but don’t use the policy. In other words, you don’t die or become disabled. (Some would say the glass is half-full in that case.) There are different types of policies that may allow some cash to build to help pay a partner upon retirement, as well.
With a clear path to their own future, your successors will work harder to ensure the success of your current business. This, in turn, will strengthen your ability to retire when you are ready. And with a succession plan in place, your successors may even pay for your gas when you decide to drive off into the sunset!