Kelley A. King, CLU, ChFC
VP, SG Financial Services, LLC
You have lived and died with the family business. Well, the “died” part may be an exaggeration. Nonetheless, you have poured your life into the business and nurtured it to be what it is today. The questions are: What do you want it to be tomorrow? Not just tomorrow, but after you are gone. Will the business go on after your heart stops beating? Do you want it to? Who will own it? Who will run it? Who will benefit from its value? These questions are just a part of the Business Succession Process and should be addressed in concert with other issues. By applying Financial Modeling tools, you can assure a balance between your personal needs and the needs of the business. This article will address one of the questions – Should Life Insurance be used as part of the overall plan?
While life insurance is not the solution to every problem, as some insurance people think, it can be an extremely effective tool in a business succession plan. Structured properly, it can provide income tax dollars which can be used in a variety of ways. It can supply tremendous leverage. For a “few dollars” of premium an insured can obtain thousands of dollars of life insurance coverage. In this situation I believe no other investment provides a “payoff” like life insurance. Here are some of the common ways in which life insurance can be integrated with many of the tools, techniques, and strategies commonly used in business succession planning:
Funding a Buy-Sell Agreement
Having a buy-sell agreement is essential. Having funds in the hands of the buyer when needed is critical as well. If funds will be needed to fund a buy-out at death, the alternatives to life insurance include:
- Establishing a sinking fund ahead of time
- Taking capital out of the business
- Making installment payments.
Note that all three of these alternatives require expensive “after-tax” dollars. The life insurance option can guarantee complete financing of the purchase from the beginning.
In a properly structured arrangement life insurance proceeds will be received income tax free. These funds can be used to fund the purchase of shares. The advantages include:
- Allowing valuable capital and cash flow to be kept in the business.
- Keeping the surviving owner from having to make costly installment payments (including interest) with after tax dollars.
- Assuring the surviving family can receive nothing less than a fair value for the business immediately. This eliminates the surviving family being dependent on the future success of the business. It also assures the active shareholder’s obligation to the surviving family is satisfied.
The selection of the right form of buy-sell agreement is critical for a variety of tax and non-tax reasons and is beyond the scope of this article. You can have the perfect agreement, but without cash to fund the purchase, it is not going to work.
In many families, not all of the children will be interested in or suited to take ownership of the business. If the business goes to the children active in the business, what about the others? Is that “Fair”? A business owner can use life insurance to provide for those children who are not involved in the business. By passing the business to the active children and providing for the inactive children with life insurance, you can equalizes inheritance for all of the children. This relieves the active children from having to purchase the interests of the inactive children — perhaps at a time when the business may be unable to afford it. It also allows you a way to provide for all of your children in a fair and equitable manner.
For many family business owners, their business is their largest asset. If the business owner’s estate is large enough, there may be estate taxes payable at death. Life insurance can provide the cash needed to pay the estate taxes. This can be helpful since the business interests cannot readily be liquidated. Life insurance should be owned “outside of the estate” so that it does not cause additional estate taxes. For example, an Irrevocable Trust can be the owner and beneficiary of the life insurance policy. Also, if funds are not needed until the death of the second spouse, then less costly Survivorship Life should be considered.
Most family businesses have family and or non-family employees that are important to the continued success of the business. To protect against the financial loss due to the death of a key employee, the company can purchase key person life insurance. Think about a founder who is key to the company’s success or a top salesperson. Losing that person would result in the loss of considerable income in the short term. Key person insurance protects the business and will compensate for that loss and help the business rebuild.
Compensation and Incentive Plans
As owners transition ownership and management of a business, attracting and retaining key employees is essential. This often involves developing compensation plans that will incentivize employees and increase the probability of them staying with the business. This can be done through stock ownership and other synthetic forms of ownership. Also, Nonqualified Deferred Compensation Plans can be used to provide benefits on a selective and discriminatory basis. These plans are designed to provide death, disability and retirement benefits. Life insurance is a popular vehicle for informally funding these plans because it offers tax-deferred cash value growth and tax-free death benefits.
It is beyond the scope of this article to delve into all of the advantages, disadvantages, and specific aspects of structuring, obtaining, funding and managing life insurance. These issues should all be addressed by qualified legal, accounting, and life insurance professionals that are working together. Life insurance is not the “end-all” of business succession planning, but it can be an extremely valuable part of an overall plan. My advice – Don’t let the life insurance tail wag the dog, but don’t ignore the life insurance tail.
The author, Kelley A. King, is VP at SG Financial Services, LLC, a wealth management and insurance services firm headquartered in Worthington, Ohio. For more information and to contact the firm, please call 614.261.0600 Ext 119 or visit www.schiffmangrow.com.
This article is intended to provide a general overview of important estate and business succession concepts. Neither SG Financial Services, LLC, nor its representatives, provide tax or legal advice, and strongly urge you to seek a qualified attorney when planning or implementing any tax planning strategy. These concepts can involve securities. They may involve the use of life insurance, which is not FDIC or SIPC insured, and are subject to the claims paying ability of the issuing carrier. Life insurance products may contain limitations and exclusions. Pricing provided is based on a point in time, and is subject to financial and medical underwriting.
Securities offered through Valmark Securities, Inc., Member FINRA, SIPC. Investment Advisory Services offered through Valmark Advisers, Inc., an SEC Registered Investment Advisor. 130 Springside Drive #300, Akron, OH 44333-2431 1-800-765-5201, SG Financial Services LLC is a separate entity from ValMark Securities, Inc. and ValMark Advisers, Inc.