Introduction
When you drive across a one-mile-long bridge spanning one of the most beautiful lakes in America, Lake Pend Oreille, into our quaint little town of 5000 people, the first business you encounter is a large condominium unit owned by a land development corporation built right on the waterfront. The next businesses are two nationally franchised convenience markets with local ownership followed by three medical buildings housing dentists, optometrists, emergency care facility, and medical doctors. Continuing down the main street, variety stores, real estate offices, law offices, insurance offices, restaurants, a surveying firm, several boutiques, art galleries, and a movie theater are nestled alongside each other.
The one thing they all have in common is not one of them is owned by an out-of-town owner; and with the exception of the restaurants, none of them hire more than ten people. Some of them have a small sign next to their business sign stating when they were established–a clothing store 1910, a tavern 1922, a real estate office 1955, movie theater 1890 (renovated 1990’s) listed on the National Registry of Historic Buildings, a candy store 2016, surveying office brand new, etc.
Each is the product of some individual desiring to be part of the American dream by taking a concept and bringing it to life. There is just something about making your own way that attracts so many to strike out on their own, knowing they will be rewarded for the success of the endeavor as well as taking the blame for its failure.
There is also a segment of the working population that is willing to share in the individual entrepreneur’s dream and help it become successful. Nearly 70% of businesses in America are sole proprietors while according to www.pewsocialtrends.org, 3 in 10 U.S. jobs are held by self-employed and the workers they hire. This reports states in 2014, 14.6 million were self-employed with 29.4 million hired by self-employed.
Due to the nature of a sole proprietor or partnership business model, when one speaks of business insurance, the difference between personal insurance and business insurance is to a large measure one of language only.
Business insurance is merely an extension of personal insurance, and as such it reflects the importance of a person’s business to the overall personal and family situation. The business is not an end in itself but rather the means to an end, the end being the security and financial welfare of the individuals involved either as owner or worker. At some point in time the owner of a business would like to replace the business sign with a “gone fishin’” sign, and the employee would like to retire as well.
In the interim, some things are out of the control of the business owner, i.e. product obsolescence, wages or fringe benefits disputes, drought, crop failure, civil commotion, competition in the marketplace, partnership incompatibility, or untimely death to name a few. All these unfortunate or unavoidable events have the potential of causing the demise of a business, with death being the only certain killer of a business. It is unavoidable and inevitable. What can be done? This is where the concept of replacing earning power comes into play. The one thing which can secure the longevity and financial future for surviving family members and employees in the event of an untimely death of the self-employed is business continuation insurance. Similar to an IT company offering a business continuity service to keep systems up and running in a distaster, business continuation insurance can keep a business solvent and running if other factors strike at the core foundation.
Before reviewing business insurance, let’s get a better understanding of the two most common business models used by entrepreneurs to secure financial opportunities for wealth accumulation–sole proprietorship and partnerships. There is a third model, corporations, but only the first two will be dealt with now, with another article on corporations to come.
Sole Proprietor Business Model
A sole proprietor business is easy to set up. It is generally owned and operated by one person and there is no need to register it with the state, prepare any bylaws or operating agreements. If, however, you have a specific trademark or service mark you may want to register with the Secretary of State. No records are required, no keeping of minutes of meetings held, nor annual reports expected. Although this is all true, it is a wise business practice to keep good financial records.
As long as the sole proprietor is alive, he or she is responsible for all facets of the business. The owner has 100% rights to profits while also having 100% responsibility of settling all claims against the business. Creditors can get to the personal assets of the sole proprietor. One cannot use the business as a way to shield personal assets in business failure. Taxes are filed under individual tax brackets and self-employment tax is paid at the 15.3% of individual income. A 1040 form is used to determine individual tax, while a schedule C profit and loss is used to determine business income which is included on line 12 of the 1040 Form. All income and profit of business is taxed to the sole proprietor whether left in the business or not.
Death means liquidation of the business because the business cannot be separated from the sole proprietor. Surviving heirs may inherit assets from the business operation but cannot continue under the deceased’s name.
Partnership Business Model
The partnership model of business is where two or more proprietors enter into a business agreement to provide a product or service to a market. If the partnership wants to register a trademark or service mark, the partnership name should be registered with the Secretary of State where the partnership is domiciled. The partnership agreement may be oral or written. Each partner is bound by the actions of the other when acting in the scope of the business. Liability is unlimited and personal assets are vulnerable to creditors. If the personal debts of one of the partners exceeds that partner’s personal share of the business and all other assets, then the balance of the debt can be taken from the remaining partner’s share. This spells tragedy for the partnership. Profits are taxed to partners based on their percent of business. Again, the 1040 Form is used for individual tax while the schedule C profit and loss is used to determine each partner’s share of business profit or loss. Physical death of either partner spells legal death of the partnership. Surviving heirs inherit the deceased’s percent of business interest but do not automatically become partners in the business.
The surviving partner becomes a liquidating trustee with the charge to close business as quickly and efficiently as possible. The value of the deceased partner’s interest is established by will, by operation of the laws of descent, or perhaps by the partnership agreement. Law does not require heirs to settle with the surviving partner unless they choose to do so. It is their right to insist upon liquidation so they can receive their interest in cash. If a partner breaches his trusteeship, he is personally liable. He may choose to continue with the day to day operation of the business; and if he makes a profit, it must be shared with heirs according to their percent of business. If he loses money, heirs can sue for his breach of trusteeship. If minor heirs are involved, any plan of reorganization must have approval of the court having proper jurisdiction.
The options for the surviving partner are all sobering.
- Attempting to form a new partnership with the deceased’s spouse or the surviving spouse’s new companion could prove unsuitable due to lack of business knowledge, no interest, concern for future viability, or personality clashes. If minor children involved, their interest must be approved by the court holding jurisdiction, and you can rest assured the court appointed trustee is going to aggressively push for liquidation;
- A partnership with an outsider brought on by the heirs selling the deceased’s interest feeling they may realize more, or the survivor finding himself avoiding liquidation by taking on an outsider, or bidding against the outsider for the heir’s interest;
- Selling out to the heirs so he is not dominated and controlled by associates undesirable to him. This means dissolution of the business which spells the end to the survivor’s business career;
- Standing on his rights and refusing to sell which forces him to liquidation, which also ends his career.
Considerations
Consider the following options available to the sole proprietor for being able to allow his or her dream to continue to bless the lives of surviving heirs and business workers.
- A very apparent solution is the liquidation of all business assets with the hope in mind that sufficient cash can be gleaned to cover future income needs of the family. One downside is, inherent in a sole proprietor business model is “blue sky” or the value attributable to the work ethic and reputation of the sole proprietor. This cannot be overlooked in any attempt to value a business for either selling the business while the owner is alive or attempting to establish a value upon death of the owner.
- It is no stretch of the imagination to suggest most sole proprietor businesses are successful due to the interest and talent of the creator. The brick and mortar left behind has value to a new owner, but the element which gives life to the business is the personal interaction between the buying public and the business owner. It takes time to build trust, so a business can continue to survive under a new name and ownership. The value of the business will be greatly depreciated due to blue sky value.
- Keeping the business operation going by allowing employees to take over the day to day operations of the business. They must now perform the functions they were hired to do as well as pick up the daily tasks of the deceased. Fortunate would be the business who had employees familiar enough with all facets of the business so they could immediately step up and perform properly. It may be with a little time and extra training the employees could be brought up to speed.
The concern would be whether the employees would want to stay around having to now perform beyond what they initially signed on to do with still no ownership rights. They might want to stay; but with their marketable skills the competitor down the street may look enticing.
- With an eye to the future, the sole proprietor could hire an individual he or she would be willing to sell business to at a later date, train that person in all facets of the business and groom him/her for the day business could be turned over. Give enough incentives to keep the individual interested in future ownership of the business.
Solutions for Sole Proprietor Business Continuation
If you have a significant investment in your sole proprietorship, a competent financial team could help you in creating a sound financial plan. This would include yourself, an attorney, an accountant, and possibly a trust officer.
The attorney and accountant can help you set up a plan to determine the value of the business, how to transfer business assets, taxation concerns, legal documents needed, how financial obligations will be met while the business is being liquidated, and how the value of the business will be paid to the deceased’s spouse through the death benefit of the policy or how the business can be sold during the lifetime of the sole proprietor. The trust officer can help manage the financial plan once initiated. This function could be absolutely essential if the surviving spouse is a spendthrift or if there are minor children involved who may need financial advice when the surviving parent passes away.
Before a great deal of time and money are spent in preparing this financial plan, see your insurance agent to determine if you have a need for the plan, to establish your ability to pay for it, and to determine if you can medically qualify for the policy to cover the plan. If you can move past these three elements, you are ready to proceed. If not, then some other method for providing funding has to be found and explored. You may have to just start a sinking fund where monthly you place funds in an account set aside for your untimely demise. Annuities, stocks, bonds, and other financial instruments may have to fill the void, with the hope that you will have sufficient time for them to accumulate funds required for liquidation.
In any event, establish early in your financial planning what you feel the business would be worth in the event of your death. A beginning point may be simply determining book value which is determined by original cost less any depreciation, amortization or impairment costs. Traditionally, a company’s book value is its total assets minus intangible assets and liabilities. This is not a good way to value the business unless it has significant assets or particularly low profits. The IRS would probably challenge that method for determining value of the business.
The method the IRS seems to be compatible with is the capitalization of earnings method. This method measures what investment you would need in order to receive adequate earnings to accomplish your financial goals. For example, if you needed $100,000 per year and you could anticipate a 7% return on your investment, that investment would be valued at $1,428,571; or if you could anticipate a 15% rate of return, the business value would be $666,666. If that rate of return could be expected across the spectrum of similar businesses, you could rest assured the IRS would accept that for taxation purposes.
With this plan now in place, the sole proprietor simply needs to concentrate on making the dream come true. He or she can rest assured the one thing he or she can’t control which could destroy the dream has been bridled and there is no need to be concerned with it.
Faithful Employee
Let’s turn our attention to the faithful employee who hooked his financial wagon to your star. What can be done to compensate that person for his or her allegiance?
Using the same financial planning, the attorney could draw up a buy-sell agreement between the sole proprietor and the employee. The agreement would include a clause spelling out the intent of the business owner to sell the business to the employee for an agreed upon amount subject to annual review, requirement for the employee to remain an employee in good standing, requirement for surviving heirs to sell the business at the agreed upon value, requirement of the employee to buy at agreed upon value, and, if the owner chooses to sell before death, a clause giving the employee first right of refusal to purchase the business.
If the buy-sell agreement is activated, the life insurance policy on the owner is issued with the owner of the policy being the employee, payor being the employee, and beneficiary being the employee as well. The employer could be the payor but could not write the premium off as a business expense; however, he could raise the salary of the employee sufficient to cover the premium and count that as a legitimate business expense. The employee’s cost of the policy will be the taxes due on the increased salary. The employee is also named beneficiary so the value of the policy comes to him income tax free and can then be turned around to pay for the value of the business upon the death of the sole proprietor. Since the employee is the owner of the policy, he has the ownership right to borrow against the cash value in the event the owner wants to retire. The loan is paid back in a manner compatible with the cash flow of the business.
Here is where a good competent accountant could really be used. He or she could help with understanding the tax consequences of business transfers and how to take advantage of taxation requirements.
This method could take such a burden from the shoulders of the surviving spouse dealing with the liquidation of a business which has lost its blue sky value and faces an uncertain financial future. The faithful employee also can take advantage of his years of experience and start building his own dream.
Solutions for Partnership Business Continuation
The partnership business model presents a more complex set of circumstances, but if properly managed the results can be very satisfying.
Where the sole proprietor business model is built around one major player, the partnership model is built around two or more individuals having a dream which can be achieved by combining the unique strengths of those individuals. For example, an auto parts and mechanical store where one partner is extremely well versed in providing parts to customers through a storefront and the other is extremely well versed in mechanical repairs more suitable to a garage front. The client can purchase parts and have mechanical work done at same location. Another would be a boutique where one partner is well versed in helping clients choose trending fashion and the other partner is an experienced seamstress for sewing custom wedding dresses.
It should be reviewed again that a partnership is easily formed. A place of operation is chosen, a sign is hung, and doors are opened for business. Each individual brings personal assets including money which are commingled under the business name. No specific legal agreement is required to be filed with the Secretary of State. Just as with a sole proprietorship, if there are trademarks or service marks unique to the business, you may want to file them with the State.
From day one here are some issues which need to be addressed:
Remember partners liability is unlimited. Each partner is liable for acts of the other when in the scope of the business.
Example, if a line of credit is established, the partnership decides to use it for procuring inventory from a competitor going out of business, and they do so. However, one partner goes on vacation, and a service truck becomes available but the partner at home can’t reach the vacationing partner to discuss the purchase with him. Knowing the truck won’t last long on the market, the partner decides to go ahead and purchase the service truck. Unbeknownst to him, his partner went on a spending spree running up a huge gambling debt, travel expenses, and hotel accommodations.
When he came home, the business hit a recession making it impossible for the partners to take a salary for an extended period of time. The one partner had anticipated such an event and had put away reserves to see him through so the future didn’t look too grim for him. Unfortunately, when it came time to pay the credit line and payment for the truck and the horrendous vacation gambling debt, the business cash flow could not meet the requirement. Since vacation and gambling debt was the personal debt of the partner, his assets outside of the partnership were to be used first; unfortunately, they were not sufficient to handle the debt, so the partnership assets were next in line. All assets of the partnership are commingled; so when the thrifty partner’s bank account was examined, the cash reserves he had set aside for rainy day became subject to seizure. They were not enough to bring the debt current, so creditors placed a foreclosure notice on the business and proceeded to liquidate assets. Needless to say, this was the demise of the partnership.
This example is sufficient to see how partnership liability can be so detrimental to a partner’s financial future.
What about the death of a partner? How impactful is that event? It can easily be summed up by stating the physical death of a partner spells the legal death of the partnership. Most graphic would be example of a see-saw. When one suddenly answers the call to come to dinner and jumps off, the other is going to come crashing down.
Heirs may acquire ownership interest but they do not automatically become partners, and they have no say in the management of the business. The surviving partner can only continue the business as liquidating trustee until the business can be disposed of, liquidated, or reorganized. The law does not say the survivor must liquidate, but it does say, “If you cannot come to a satisfactory understanding with the heirs and organize the business under an agreement which is satisfactory to all the interested parties, it is your duty, as liquidating trustee, to close the business as quickly and as efficiently as possible. If minor heirs are involved, any plan of reorganization must have approval of the court having proper jurisdiction.”
This leaves these alternatives:
- Form a new partnership with deceased’s spouse and minor children. This may saddle the surviving partner with a widow who has no interest or skill in the business; and if minor children are involved, the surviving partner must deal with trustee of those minor children. If the widow remarries, the surviving partner may be saddled with a hostile partner who again may have no skills or interest but who does have the right to review day to day operations of the company and demand moneys be paid to the surviving heirs based on their percent of interest in the business.
- Partnership with an outsider. Heirs may feel selling will realize them more than continuing business operations. The survivor may find himself avoiding liquidation only by taking on an outsider or bidding against the outsider for the heirs’ interest.
- Sell out to heirs. The survivor must sell in order to keep himself from being dominated and controlled by associates undesirable to him. Trying to establish a fair market value may be difficult since the law does not require heirs to sell; and if there has been no partnership agreement establishing value, it is almost impossible for the surviving partner to receive anything more than a “fire sale” valuation.
- Stand on his right not to sell but refusing to sell only creates other problems. If he continues business, he must contend with the surviving spouse and or minor children wanting an accounting of business dealing. If the business remains profitable, the surviving spouse still gets the deceased’s percent of profits. If the business become insolvent, heirs can demand an accounting for loss and for the surviving partner to pay that loss due to breach of his duty as liquidating trustee.
- Survivor takes over business by operation of buy sell agreement drawn up by partners prior to either of their deaths.
This agreement is a legal instrument in which interests of each partner are identified. It is an arm length transaction in which a willing buyer and a willing seller agree upon the value of the partnership and then agree that upon the death of one partner the surviving partner will buy out heirs’ interest at a foredrawn amount and the deceased heir agrees to sell at that same amount. With this simple instrument, the surviving partner maintains the ability to earn a living without encumbrances imposed by the other alternatives listed above. The deceased heirs receive fair settlement and are free to pursue other interests without worrying whether the business will remain profitable and capable of providing an income cash flow to them.
This whole solution is possible by each partner purchasing a life insurance policy on the life of the other partner equivalent to the agreed upon valuation. This is referred to as a cross purchase agreement. Each is the owner, payer, and beneficiary of the life insurance policy on the other. When death occurs, the death benefit comes to the beneficiary income tax free and is then disbursed to the deceased’s heirs to buy out the deceased share of partnership. The heirs also get to receive that value on a stepped up basis so there will be no capital gain tax due.
When a married couple are partners in a business and then they divorce, this can be a very complex path to navigate. Attorneys like Debra Schoenberg, of Schoenberg Family Law Group, specialize in helping couples navigate complex property division. Debra Schoenberg’s Reviews make it clear that she has helped clients successfully through such a minefield.
Summary
Something which has become apparent as we have reviewed the use of life insurance to solve the business continuation dilemma is this–life insurance is the same whether being used to replace personal earning power or business earning power. We have just used language which is more applicable to the issues at hand.
It is also apparent that for life insurance to work in a business setting, the assembling of a competent financial team is critical. Attorney, accountant, trust officer, and insurance agent along with your guidance can combine their expertise to avoid future pitfalls. It has been my experience that due to the nature of his business, the life insurance agent makes a good captain for this team. He has a vested interest in moving things along because he receives no compensation until an insurance product is sold and paid for. Attorney, accountant, and trust officers receive their compensation based on billable hours or set fees and have no real incentive to expedite the process. It is a wise client who will allow each of these professionals to do their due diligence in the area of their expertise. Though they may have some understanding of each others’ roles, they should also be mature enough to allow discussion to occur regarding the final output. It makes a lot of sense in establishing business insurance plans to meet early with these professionals so a plan of action with deadlines can be agreed upon. Time slips away, and to have one person designated to keep things moving will help you avoid a lot of frustration with everything else you need to pay attention to in your quest to achieve your financial dream.
Yes, your home is your castle, but your business is your kingdom. Guard and protect it well, for if you do your castle will always be secure.
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