According to a recent study by U.S. Trust, 64% of millionaire business owners over 50 have no formal succession plan.¹ While the number may shock you, it is not surprising that many small business owners are consumed by the myriad responsibilities of running their businesses.
Nevertheless, owners ignore succession planning at their peril, and possibly at the peril of their heirs.
There are a number of reasons for business owners to consider a business succession plan sooner rather than later. Let's take a look at two of them.
The first reason is taxes. Upon the owner’s death, estate taxes may be due, and a proactive strategy may help to better manage them.² Failure to properly plan can also lead to a loss of control over the final disposition of the company.
Second, the absence of a succession plan may result in a decline in the value of the business in the event of the owner’s death or unexpected disability.
The process of business succession planning is comprised of three basic steps:
- Identify Your Goals: When you know your objectives, it becomes easier to develop a plan to pursue them. For instance, do you want future income from the business for you and your spouse? What level of involvement do you want in the business? Do you want to create a legacy for your family or a charity? What are the values that you want to ensure, perhaps as they relate to your employees or community?
- Determine Steps to Pursue Your Objectives: There are a number of tools to help you follow the goals you’ve identified. They may include buy/sell agreements, gifting shares, establishing a variety of trusts or even creating an employee stock ownership plan if your desire is that employees have an ownership stake in the future.
- Implement the Plan: The execution step converts ideas into action. Once it's implemented, you should revisit the plan regularly to make sure it remains relevant in the face of changing circumstances, such as divorce, changes in business profitability, or the death of a stakeholder.
Keep in mind that a fundamental prerequisite to business succession planning is valuing your business.
As you might imagine, business succession is a complicated exercise that involves a complex set of tax rules and regulations. Before moving forward with a succession plan, consider working with legal and tax professionals who are familiar with the process.
Insuring Your Business With a Buy/Sell Agreement
Tip: All in the Family. Family owned businesses account for 62% of total US employment and are responsible for 78% of all new jobs. Yet only about 30% of them survive into the second generation.
Source: Conway Center for Family Business, 2015
Life insurance is designed to help protect a household from the financial hardships that may follow the untimely death of a primary wage earner.
But how will a death affect a small business?
One way of safeguarding a business is to create a buy-sell agreement. A buy-sell agreement is a contract between different entities within a corporation to buy out the interests of a deceased or disabled member. A buy-sell agreement also can protect the business from loss of revenue and cover the expense of finding and training a replacement.
Types of Buy-Sell Agreements
There are two main types of buy-sell agreements commonly used by businesses:
Cross-Purchase Agreement. In a cross-purchase agreement, key employees have the opportunity to buy the ownership interest of a deceased or disabled key employee. Each key employee takes out a policy on each of the other key employees. Cross-purchase agreements tend to be used in smaller companies where there are not too many key employees to cover.
Stock-Redemption Agreement. Stock-redemption agreements are formal agreements between each of the key employees—and the business itself—under which the business agrees to purchase the stock of deceased key employees. Key employees agree to sell their shares to the company, often in exchange for a cash value.
These agreements establish a market value for a key employee’s share of the company.
Funding a Buy-Sell Agreement
There are several options for funding a buy-sell agreement:
Set Aside Funds. Money for a buy-sell agreement can be set aside, as long as it is easily accessible. These funds must be kept up for the life of the company, and may present a temptation during fiscally tough times. The business owners must determine the appropriate amount needed to cover the cost of a buy-out.
Fast Fact: What’s the Right Time? A buy-sell agreement can be put into place at any time, but it often makes sense to do so when a business is formed or when a new partner is brought in.
Borrow the Needed Amount. A company can borrow enough to buy out a withdrawing key employee at the time of his or her death. However, the loss of the employee can often affect a company’s ability to secure a loan, and the payments become an added stress on the business during an already difficult time.
Life Insurance. Purchasing a life or disability policy in order to fund a buy-sell agreement is an option when preparing for the future. Using life insurance enables a buy-sell agreement to be funded with premium payments and attempts to ensure that funds will be available when they are needed.
Several factors will affect the cost and availability of life insurance, including age, health, and the type and amount of insurance purchased. Life insurance policies have expenses, including mortality and other charges. If a policy is surrendered prematurely, the policyholder also may pay surrender charges and have income tax implications. You should consider determining whether you are insurable before implementing a strategy involving life insurance. Any guarantees associated with a policy are dependent on the ability of the issuing insurance company to continue making claim payments.