Do your clients need a pre-nup for their business?
Many are familiar with pre-nuptial agreements between soon-to-be husbands and wives. But, what about people going into business together?
What is a buy-sell agreement?
An arrangement through which two or more owners of a business determine the conditions and price at which they will sell shares to each other. The agreement may establish events that trigger a share exchange, such as death, disability or retirement. It may also specify a formula for valuing each owner’s shares, and identify source(s) of buy-out funding.
Smoothing the transition
For closely held or family businesses, a properly designed and funded buy-sell agreement can save time, hassle and money, similar to a pre-nup for couples. In the end, it could actually save the business too.
- Less than 1/3 of family businesses survive the transition from 1st to 2nd generation ownership.1
- Another 50% don’t survive the transition from 2nd to 3rd generation.1
Why is it so difficult to make a smooth transition? Often, the reason is because the owners didn’t have a plan in place to continue the business after an owner’s retirement, disability, divorce or death. This is what a buy-sell agreement is designed for.
Benefits of a well-designed buy-sell agreement
Not only will a buy-sell agreement describe the terms under which ownership interest in the business can and will be transferred, it can also establish:
- A pre-determined method for how the business interests will flow.
- A market value for the business, or the way in which the value will be determined in the future. This can eliminate huge hassles (and arguments) later.
- A funding source for the purchase of the ownership interest, and the payment terms for the sale of the business. Without proper funding, the buyer may have to sell assets, take out loans or even file for bankruptcy.
- Restrictions, such as who can own the business or how to transfer or sell ownership interests.
Why fund with life insurance?
Your clients can purchase interest in a business by borrowing from a bank, or making installment payments. However, many people choose to fund a buy-sell agreement with permanent, cash value life insurance because if offers:
- Immediate liquidity – If the owner passes away, the death benefit is available (generally income-tax-free) to fund the business sale.
- Available cash value – After funding the policy for a number of years, cash surrender value may be available to use for the business sale or other expenses.
- Cost efficiency – Initially, the premiums are significantly lower than the benefit itself, and can be much lower than the cost of a loan, so there’s no large outlay from the business.
- Stability – A life insurance benefit from a highly-rated company can add stability to the agreement.
1 Source: “The Facts of Family Business,” Forbes, July 31, 2013
Under current federal tax rules, clients generally may take federal income tax-free withdrawals up to their basis (total premiums paid) in the policy or loans from a life insurance policy that is not a Modified Endowment Contract (MEC). Certain exceptions may apply for partial withdrawals during the policy’s first 15 years. If the policy is an MEC, all distributions (withdrawals or loans) are taxed as ordinary income to the extent of gain in the policy, and may also be subject to an additional 10% premature distribution penalty prior to age 59½, unless certain exceptions are applicable. Loans and partial withdrawals will decrease the death benefit and cash value of the life insurance policy and may be subject to policy limitations and income tax. In addition, loans and partial withdrawals may cause certain policy benefits or riders to become unavailable and may increase the chance the policy may lapse. If the policy lapses, is surrendered, or becomes an MEC, the loan balance at such time would generally be viewed as distributed and taxable under the general rules for distribution of policy cash values.
Please be advised that this webpage is not intended as legal or tax advice. Accordingly, any tax information provided is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed, and clients should seek advice based on their particular circumstances from an independent tax advisor. Neither Equitable nor its affiliates provide legal or tax advice.