Business Succession Planning for the Sole Owner

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Business Succession Planning for the Sole Owner

• One-Way Cross-Purchase Buy-Sell Agreements

OLA 1957 0509
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This material was not intended or written to be
used, and cannot be used, to avoid penalties
imposed under the Internal Revenue Code. This
material was written to support the promotion or
marketing of the products, services, and/or
concepts addressed in this material. Anyone to
whom this material is promoted, marketed, or
recommended should consult with and rely solely
on their own independent advisors regarding
their particular situation and the concepts
presented here.
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The Sole Owner Different from Multi-Owner
Companies

• Problematic incapacity or premature death
• No co-owners to run company in interim
• No obvious successor
• May cause termination of entity
• Loss of stream of income for family
• Fire Sale loss of significant percentage or
  ALL value

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What happens at owners death?

• Termination of business
• Sole Proprietorships
• Partnerships
• Professional Corporations
• Managed by Executor
• S Corporations
• C Corporations
• Limited Liability Companies

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Bequeathing Business via Will

• Common approach, but why is this a problem?
• Family members
• Children often not involved in business
• Executor may not want to run business
• Successor not fully trained/mentored
• May not be qualified lack professional
  certification
• Owner associated with Entity
• Loss of owner results in loss of goodwill
• Personal relationships with clients
• Personalized service only owner provided

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One-Way Cross-Purchase Buy-Sell Agreement

• An alternative strategy.
• The owner will have negotiated a sale to a
  selected buyer prior to death
• A sale is agreed to at a set price at a
  triggering event (death, retirement, disability,
  specified date, etc.)
• Entity redemption not an optionentity cannot
  exist without an owner/manager of operations.

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One-Way Cross-Purchase Buy-Sell Agreement
Pool ofPotential Buyers
Key Employee
Competitor
Relative
Potential Buyer
Friend/ Colleague
Unrelated Third Party
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One-Way Cross-Purchase Buy-Sell Agreement

• Buy-Sell Agreement contracts vary in terms, but
  allcontain following mandatory provisions

• The owner (or his/her estate) will sell to the
  specific buyer, and the buyer will purchase the
  business interest from the owner
• An agreed upon price or formula to value the
  business
• Specified list of assets and liabilities to be
  transferred
• A means of funding, such as life insurance, is
  chosen so buyer is capable of making purchase

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Funding the Agreement Term vs. Perm

• Parties to agreement often want to fund with term
  insurance,
• due to lower premiums, but permanent insurance
  may be more
• appropriate because
• Triggering event for buyout often occurs for
  reason other thandeath (e.g. retirement,
  disability, specified date)
• Buyer can use cash accumulation in a permanent
  policy to fund a lifetime buyout
• Permanent policy with cash value build-up works
  better for a long held, well-established
  business
• Length of agreement may extend beyond time that
  term isavailable (gets too costly after a
  certain age)
• At time participants want to switch to permanent,
  insured may be in poor health or uninsurable.

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Key Executive as Buyer Executive Bonus

• Candidate to replace owner Key Executive in
  Business
• As salaried employee, may lack funds for buyout
• Owner can implement Executive Bonus arrangement
  to fund policy
• Premiums are paid through taxable bonus to
  executive
• Employer receives a 162m deduction (as
  compensation)
• Executive purchases life insurance policy
• Executive is owner and beneficiary of policy
• Employer may add double bonus to cover
  estimated income tax liability to Executive on
  both bonuses
• Premiums are not tax deductible for Executive
• With a Restricted Bonus, executive has limited
  access to cash value of policy based on certain
  events (e.g. disability of owner)

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Executive Bonus Heres How it Works
Bonus Payment Employer makes taxable bonus
payment to executive and receives corresponding
income tax deduction.1 Executive reports bonus as
additional income.
Life Insurance
Employer
Life Insurance Purchase Executive uses bonus
payment (minus income taxes) to purchase life
insurance policy. Accessing Benefits Executive
has access to policys cash value at
predetermined time or specified event. Executive
receives death benefit, used to fund buyout of
owners business interest.
Executive
1 Provided amount of bonus is reasonable and
employer retains no ownership rights or
beneficial interest in the policy.
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Using an Escrowed Buy-Sell Arrangement

• Setting up the buy-sell agreement with an Escrow
  as intermediary
• can serve many purposes
• Ensures enforcement of the arrangement
• Prevents likelihood of buyer unilaterally backing
  out of agreement after owners death, and
  keeping policy proceeds.
• Custodian of life insurance policy
• Ensures payment of premiums
• Prevents access by creditors
• Preserves integrity of policy (prevents policy
  withdrawals, which could cause lapse)

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One-Way Cross-Purchase Buy-SellHeres How it
Works

• Example
• Felix owns cleaning service, sole proprietorship
• At his death, company would liquidate
• Goals To ensure his wife and children are taken
  care of after his death with a lump sum or stream
  of income

Felixs Cleaning Service Felix, Sole Proprietor
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How it Works Example Felixs Cleaning Service

• Example
• Oscar was once one of the worst employees
• After many years, Oscar has shaped up and is the
  best, and manages all the other cleaners
• Goals Felix decides to choose Oscar to take over
  the business when he leaves. Oscar jumps at the
  chance.

• Oscar, Head Cleaner
• Key Employee

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How it Works Diagram Felixs Cleaning Service
I. During Felixs Life
Sole Proprietorship (Cleaning Service) Sole
Proprietor (Felix/Felixs Estate)
2) Employee Bonus/Employer Deduction
1) Buy-Sell Agreement
3) Income Tax on Bonus
4) Premiums
IRS

• Transamerica
• Policy
• (on Felix)

• Buyer
• (Oscar - Key Employee)

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How it Works Diagram Felixs Cleaning Service
Sole Proprietorship (Cleaning Service) Sole
Proprietor (Felix/Felixs Estate)
II. At Felixs Death
8) Income Tax on IRD
7) Business Interest
6) Sale Proceeds
5) Death Benefit
IRS

• Transamerica
• Policy

• Buyer
• (Oscar - Key Employee)

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Tax Consequences

• If employee bonus used
• Deduction allowed for business
• Income must be recognized by Key Employee/Buyer
• Generally, policy death benefit federal income
  tax-free
• Owners estate receives step-up in basis at
  death, so no capital gain in business likely to
  be realized
• Income in Respect of a Decedent (ex. notes,
  accounts receivable, commissions received after
  death, substantially appreciated inventory)
• No step-up in basis at death
• Subject to ordinary income tax
• If buyer predeceases owner, value of life
  insurance policy is included in buyers estate

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Effect of Estate Basis Step-Up
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Advantages

• Known buyer at death or retirement
• Plan for management of business at death or
  retirement
• Sale proceeds a source of income for family
• Pegged value of business

Sole Owner

• Offer to own business
• Funding (life insurance) to pay purchase price
• Basis in business interest equal to purchase
  price

Key Executive/ Buyer
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Transamerica Life Insurance Company, Transamerica
Financial Life Insurance Company (collectively
Transamerica), and their representatives do not
give tax or legal advice. This material is
provided for informational purposes only and
should not be construed as tax or legal advice.
You should rely solely upon your own independent
advisors regarding your particular situation and
the concepts presented here. Discussions of the
various planning strategies and issues are based
on our understanding of the applicable federal
tax laws in effect at the time of presentation.
However, tax laws are subject to interpretation
and change, and there is no guarantee that the
relevant tax authorities will accept
Transamericas interpretations. Additionally,
this material does not consider the impact of
applicable state laws upon clients and
prospects. Although care is taken in preparing
this material and presenting it accurately,
Transamerica disclaims any express or implied
warranty as to the accuracy of any material
contained herein and any liability with respect
to it. This information is current as of April
2009. Transamerica Financial Life Insurance
Company is authorized to conduct business in the
state of New York. Transamerica Life Insurance
Company is authorized to conduct business in all
other states.
OLA 1957 0509
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Business Succession Planning for the Sole Owner
One-Way Cross-Purchase Buy-Sell Agreements
OLA 1957 0509