Business Succession Plan is Integral to Business Strategy

October 6, 2017|

By Kurt Mueller

The equity in a small-business owner’s company is a valuable asset. But in a pri- vately held company, how can equity be converted to cash when the owner exits the business?

Creating an exit plan – commonly called a “succession plan” – is an integral part of strategic business planning. Here’s how.

The Tax Impact at an Owner’s Exit

Succession  planning,  which  involves passing ownership to an heir or selling the company, aims to achieve an optimal outcome for the business, which includes converting   business   equity   into   cash whenever necessary. This goal is important for two reasons:

  1. At     retirement,   business     owners usually want to enjoy themselves or pursue  other  opportunities.  After  giving up control, they don’t want to worry  about  the  health  of  their  business.
  1. An owner’s heirs may lack the knowledge or interest to manage the business-and may prefer, at the owner’s death, to liquidate it. The value of a business passed to heirs is included in the owner’s estate at death and could be subject to federal estate tax. These taxes must be paid in cash, and the filing deadline for federal estate taxes is nine months after the date of death, unless an extension is requested. Federal and  state  governments  require  cash  to settle taxes – regardless of the status of the business in the wake of the owner’s death.

In the worst cases, valuable businesses have been sold at “fire sale” prices simply to meet estate tax obligations. Heirs  may  also  need  cash  for  other reasons, such as business debts and obligations, probate and attorneys’ fees, the cost of business appraisals, audits and the costs of closing down the business. Consequently, almost  every  business  needs cash to work through the transition in ownership. Providing this cash is one of the most important steps in the succession planning process.

Three Key Questions

One starting point for business succession planning is to ask and answer three questions:

  1. What is the business worth now on “fair market value” basis? Fair market value is the amount that a willing buyer would pay a willing seller in an arm’s-length negotiated transaction. (A business appraisal conducted by a qualified professional can help to answer this question.)
  1. What will  the  business  be  worth when   the   owner   exits?   Any   future growth in revenues or profits should increase business value – as should the grooming  of  one  or  more  successors.
  1. How will heirs obtain a fair value for the business when the owner exits? One solution, called a  buy-sell  agreement, pre-determines the terms of a sale (in- cluding transaction price) and may also pre-determine the funding mechanism necessary to complete the sale and help pay expenses and taxes.

Terms of a Buy-Sell Agreement

A buy-sell agreement may be formed between co-owners or partners, who each agree to buy out the other’s interest upon a “triggering” event. Alternatively, it may involve the current owner and a designated successor owner, perhaps a family member or top manager. Most buy-sell participants lack the personal resources to buy a partner or owner’s business interest outright. Since most business owners prefer to receive cash at the  closing, strategic  planning  requires that the source of the cash be identified well in advance. Often, the primary source is permanent life insurance. The death benefit is a cost-effective way to fund a death buyout and the cash value component can be  utilized  for  lifetime  buyout  events.

Valuing the Business

After a successor is identified, the next step is to determine the buy-out value. Although  small-business  owners  have some flexibility in setting the price of a buy-out transaction, the IRS and courts require  a  valuation  that  represents  fair market reality. Some valuation methods include:

  • Comparable recent       transactions   –   Business   value   is   based   on the  terms  of  sales  or  mergers  involving   companies    of    comparable   size in  the  same  industry  or  market  area.
  • Multiple of  revenue  or  book  value

–  Business  value  may  be  pegged  to  a multiple  of  gross  revenues  in  the  year or two just before the owner exits. For example, some service-oriented busi- nesses  may  sell  for  about  one  to  two times  annual  gross  revenues.  Or,  the value may be pegged to an audited bal- ance sheet as a multiple of “book value.”

  • Discounted cash flow – The value is based on total cash flow that the busi- ness is projected to generate for a period of years (typically three to five) after the owner’s exit, discounted by a cost of capital. Drafting the Legal Agreement

The next step is to formalize the buy- sell agreement in writing with the help of an attorney experienced in succession planning – and ideally, one who also has a background in estate tax planning and business  valuation.  An  important  sec- tion of the agreement defines the “trig- ger events” that will require ownership to change hands. Common trigger events include an owner’s death, disability, re- tirement, divorce, or separation from employment. When a buyout is triggered by an event other than death, the legal agreement also may include provisions that prevent the departing owner from competing against the company or dis- closing its trade secrets.

Funding the Buy-Sell Agreement

As  noted  earlier, permanent  life  insurance  is  often  used  to  fund  buy-sell  agreements.  This  is  because  coverage   can   continue,   and   premiums remain   constant,  at   any   age.  Funding  these  agreements  with  permanent life  insurance  also  has  other  benefits:

  • Quick and convenient cash for heirs – Life insurance solves the problem of turning an illiquid asset (the business) into cash.
  • Tax advantages – Life insurance pays a death benefit that is generally free of federal income taxes. In buy-sell agreements, the benefit is usually paid to the party  who  has  the  obligation  to  buy the  shares:  the  surviving  shareholders or  outside  buyer  –  so  the  death  benefit does not create estate tax conse- quences for the estate of the deceased.
  • Affordable, level premiums – Per- manent life insurance   can   be   pur- chased    at    affordable    level    premi- ums,    especially    when    the    insured person is fairly young and in good health.
  • Cash value – The cash value of a perma- nent policy can provide buyout funds if an owner exits at a lifetime triggering event, such as a divorce or normal retirement. Most agreements include provisions for terminating the buy-sell agreement by mutual consent or if specified events oc- cur. In such instances, the policy’s owner can recoup part of the premium cost from the cash value.

Planning for a Long-Term Disability

One trigger event that can be funded with insurance is an owner’s long-term disability. In this case, disability income insurance  can  be  purchased  to  fund an obligation written  into  the buy-sell agreement. Subject to the terms of the policy, disability buy-out insurance pays to the business beneficiary or other owner a stated amount of money or periodic income (after a waiting period) that can be used to fund part or all of the buyout.

Successful business owners rarely stop working long enough to ask why they are working so hard. But ultimately, most are striving to achieve a certain level of security for themselves and their loved ones. With the right succession planning, small-business  owners  can  help  to  ensure both the long-term success of their business and  greater  financial  security for themselves and their family for many years to come.

Prepared by The Guardian Life Insur- ance Company of America. The information contained in this article is for general, informational  purposes  only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal adviser regarding your individual situation.

Kurt Mueller is an independent financial advisor for the Consolidated Planning Group and worked on prep- aration of this article with The Guardian Life Insurance Company of  America. The information contained in this article is for general, informational purposes only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice.  You should consult your tax or legal advisor regarding your individual situation. To make an appointment with Kurt—call 803.671.8792 or email kmueller@cplanning.com

 

 

 

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