Isn’t it exciting to see our economic engine coming to life in this land of opportunity! All up and down the economic spectrum people are finding ways to make their financial dreams come true. This is particularly true of individuals starting businesses of their own where they get to choose which 18 hours a day they are going to work!! Joking!! They are willing to do so because they have their own skin in the game. At the end of the day they can say they made it on their own when they succeed and on the other hand they have no one to blame for their failure if they fail. They can say as the poet said, “Success was never made by sudden flight, but while their companions slept they toiled upward in the night.”
What happens to that dream when life slips away from the dreamer? Does it also die or is there a way to preserve it into the next generation and the next generation, etc?
Absolutely! A well drawn up continuation plan creates a path for the beneficiary or beneficiaries of the business to continue without any interruption or delays.
The three basic structures of business are sole proprietors, partnerships, and corporations. Each of these have their unique requirements to be met for them to continue.
The overwhelming majority of businesses in our economy are sole proprietors. These are hardy souls who have a dream that perhaps keeps them up at night until they finally take a leap of faith, hang out their business shingle, go to work and now lose sleep over how to keep it going!
A sole proprietor business model:
- Generally entails just one business owner.
- Has very few employees with the success of the business riding on the expertise of the sole proprietor.
- Only lives for the duration of the life on the sole proprietor.
- Is subject to economic whims in the market place.
Here is a real life story.
A young man started working as an apprentice carpenter right out of high school. He excelled at his craft and found real excitement in building miniature size “castles.” His fame grew as more and more of his houses bore testimony to his skills. He hired a couple of other fellows to help with the basic elements of the house, leaving him to put his signature flair on his projects. He also discovered he needed someone who understood business practices, accounting procedures, payroll, and advertising so he added a business manager to his staff.
As the years went by he found the business manager had the same zeal for the business and he felt he may lose him to his own dream. He decided to draw up a proposal where the manager could see he could either buy out the business in the event of the sole proprietor retiring or becoming disabled or inherit it in the event of the death of the proprietor. This was extremely interesting to the business manager and he quickly agreed to the terms.They went to a lawyer friend who advised them to draw up a buy-sell agreement. In this agreement they agreed to the terms of how ownership could change and they also agreed on the value of the business. Since there was a willing buyer and a willing seller, the value would stand up in a court if there were any questions as to the validity of the business value.
Now the question on where business manager would get the funds necessary to complete the agreement would come from had to be addressed. He said he did have some savings he would be willing to put into an escrow for the purpose of retiring the debt he would incur, but it would take considerable time for him to add to the escrow– what would happen if he didn’t have sufficient time?
In reviewing his other business insurance with his insurance agent, the sole proprietor told him about the agreement and the dilemma on how to provide necessary funds. The agent enthusiastically declared, “Why don’t you fund it with a life insurance policy on you and one on him?”
Simple concept. A permanent life insurance policy was written on each for the value agreed upon in the buy-sell agreement with the ownership on each policy being retained by the business, and each of the sole proprietor and business manager named as beneficiary on the other’s policy. The premium on both policies were to be paid by the company even though they could have been paid individually. The manager agreed to continue putting money into escrow with the understanding if the cash value of the life insurance policy was not sufficient to compensate the owner upon retirement or disability those funds could be called upon. In the event of death of the owner, the face amount of the policy on his life would go to the business manager who would then, due to the agreement in the buy-sell agreement, turn the funds over to the business owner’s heirs for the ownership of the business to transfer. Money in escrow would return to the business manager.
Why, you say, should you have a life insurance policy on the business manager? Several reason come to mind.
(1) This business manager is very valuable to the business due to his expertise and experience. It may take some time to replace him, so the death benefit could be a stop gap for the owner to use to cover his expenses of trying to find another qualified employee.
(2) Cash value could act as “golden handcuffs” which, after the employee had been with the company for a certain period of time, could be given as a bonus or kept until the employee retired and then used to fund retirement along with any other plans in place and.
(3) Cash value shows as an asset to the business so helps to increase value of business.
It is worth noting that none of these payouts are taxable to the owner of the business and none of them require a pay back like a loan would require. Talk to your agent or other advisors for more details on the taxation, payment options, and liability involved with being a sole proprietor.
Much of the business model for a sole proprietor applies to a partnership, with the exception that now two or more people agree to pool their resources to make a business function. Let’s use an automobile parts store/mechanic shop for our example and leave to another time a narrative of limited liability partnerships, public liability partnerships, etc.
Bob has great skill as a mechanic while Ed brings exceptional knowledge of auto parts store operations. Having an automobile parts store and a mechanic shop under the same roof drives business to both functions of the business. Employees can be crossed trained, and all business accounting procedures are shared as well.
In a partnership business arrangement, the individual partners’ personal assets as well as the assets transferred to the partnership are subject to liability exposures. It cannot be emphasised enough that decisions made by one partner are binding on all other partners. If one partner gets into debt over his ability to meet his obligations and declares bankruptcy, his portion of the business must be listed as one of his assets. Since it cannot be determined which portion of the business belongs just to him, the whole business operation may have to be liquidated to satisfy that partner’s financial obligations. This may be the primary reason so few partnerships ever get off the ground or why partners decide to incorporate.
What about an untimely death? Would you like now to be in business with the deceased spouse who is ignorant of the day-to-day operations, who has no business skills they can bring to the table, who wants to get out of the business, or who just wants to collect a paycheck from the ongoing business operations? How would you like to be in business with the surviving spouse’s next husband or wife? Here again the problem of transferring ownership when one partner wanting to quit, retirement, disability, or death raises its head. Complicated issued which require legal assistance to keep from serious headaches down the road. . . “You can’t order up the parachute when the plane is coming down.”
Let’s deal with transferring ownership at time of death and perhaps a slight mention of transferring ownership upon a partner’s retirement.
With a properly drawn up buy-sell agreement and business valuation being completed, each partner’s share of the business can be determined and addressed accordingly. For the sake of simplicity, we will have two partners and their wives and equal ownership. Life insurance applications for the amount of each partner’s interest normally would be submitted for the persons involved in the day-to-day operations. Having willing buyers and willing sellers, for estate tax purposes, the amount agreed upon would be acceptable to the IRS in most cases.
The partners have a policy where each is listed as insured, the other partner being the beneficiary, and either the business or the other partner being the owner. Since this is to cover a business expense, the premium payer should be the business, thereby giving assurance that, no matter what, the premiums will always be paid on a timely basis. Likewise, the business could also be listed as owner so any decisions regarding the life insurance policies would have to be made in public by the consenting partners.
When death occurs, if the surviving partner is named beneficiary, the death proceeds would go directly to him. He would then fulfill the commitment agreed upon in the buy-sell agreement that the surviving partner would buy out the interest of the deceased spouse for the agreed upon amount. The deceased spouse fulfills her agreed upon arrangement that she would sell to the surviving partner the value of the portion of the business. This is done and the surviving partner has full control of the business and the deceased spouse”s survivor is relieved of ownership concerns and has money to go on living.
The funds from the life insurance company comes to the surviving partner income tax free due to the favorable tax status of life insurance death benefits. It is paid out tax free by the surviving partner, but it may have some tax consequences to the deceased’s surviving spouse since it paid for the business value which may have tax ramification. In the event the business was named as owner and beneficiary, the funds would come to the business who would then in turn meet the buy-sell agreement provision which would have instructed the business to purchase the value of the deceased partner. There would be no taxable event to the owner (the business) but may have some for the deceased spouse’s estate. Here again, proper legal, accounting and insurance advice from the beginning can help alleviate future problems. Legal advice tells you how to set up the business, accounting helps determine amounts of expenses to be incurred and the life insurance agent provides the means to meet those financial obligations. One last comment, the premium being paid is not normally tax deductible for either the business or either partner since the death benefit has such a favorable tax break. Sometimes the company will raise the salary of the partners to offset the increased outlay which becomes a business expense and can be written off as a legitimate business expense. The increased salary is received by the partner, and his actual expense for the insurance then becomes the tax he owes against the increased salary.
What about retirement? Well, if permanent insurance was used to fund the buy-sell agreement, a provision would be written into the agreement that upon retirement the partnership would pay as deferred compensation an amount equal to the cash value in the life insurance contract. The company could borrow from the cash value to pay that amount and if they chose to do so continue the life insurance policy, and then upon the death of the retiree receive the death benefit minus loan and accrued interest income tax free to increase the cash reserves of the business. You don’t have to just die in order for life insurance to enhance your financial future!
Bob was working at the auto parts counter one morning when a hot tempered client came storming into the store asking for the owner of the establishment. Bob stepped forward and was met by a tirade about how the client had almost lost his life because the front wheel which Bob’s mechanic had worked on had broken loose, causing his car to run into the ditch. Finally getting the man to calm down, the truth of the situation was discovered–the man had heard a noise coming from the front wheel when he turned a corner and had stopped to see what it was. It turns out the bolts on the wheel hadn’t been tightened like they should have by the mechanic when he reinstalled the tire and the wheel had made the rumbling sound heard by the client. No damage was done but Bob refunded all the money they had collected to do the job, which satisfied the client and he left the store.
Seeing what the potential loss could have been and knowing that in the partnership he had with Ed their business and individual personal assets were exposed to lawsuit, he called Ed and said, “It’s time we incorporate.” Hearing the narrative, Ed quickly agreed and called their attorney to set up a time when they could accomplish the incorporation.
Along with doing all the paperwork for incorporation, another buy-sell agreement was drawn up to properly handle the potential need to transfer ownership from one to the other. The same concerns they had for transferring the business as partners were now addressed in the setting of a corporation. Now they were no longer partners but shareholders in the newly established business “American Services.” It was good timing for both of the partners because Bob had a son-in-law who was a rising star, being well versed in both the auto parts and mechanical sides of the business. Ed was feeling like making a change in where they lived and preparing for retirement, so he wanted to reduce his share of the business. It was determined then to offer a 20% share of the business to Joe, the son-in-law, leaving Bob with 50% and Ed with 30% of the outstanding shares offered by the company. A reasonable book value of $1000 per share was agreed upon and 1500 shares were issued– 300 to Joe, 750 to Bob and 450 to Ed. Life insurance policies with face amounts of $300,000 on Joe, $750,000 on Bob and $450,000 on Ed were applied for and upon underwriting policies were issued. It was also noted in the annual stockholder meeting report that an audit to determine values would be performed yearly so shares would properly reflect value of business.
Since the percentage of ownership was wanted to be maintained by the shareholders in the event of any shareholder’s death, the business was named as owner, beneficiary, and payer on each of the policies. Consequently, the buy-sell agreement stated the business would purchase the outstanding shares from the deceased shareholder’s spouse and would retire the stocks which would become company-owned. .
When a hot tempered client comes through the door of the business now, Bob, Ed, and Joe can rest assured the pillow they go to sleep on at night is protected against any such assault. .
In summary, the above is a very brief narrative on business continuation insurance but it is a good jump off point for meaningful conversations with your financial advisors.