Planning for Business Succession

Funding a Buy-Sell Agreement with Life Insurance

As a partner or co-owner (private shareholder) of a business, you’ve spent years building a valuable financial interest in your company. You may have considered setting up a buy-sell agreement to ensure your surviving family a smooth sale of your business interest and are looking into funding methods. One of the first methods you should consider is life insurance. The life insurance that funds your buy-sell agreement will create a sum of money at your death that will be used to pay your family or your estate the full value of your ownership interest.

How funding with life insurance works

When using life insurance with a buy-sell agreement, either the company or the individual co-owners buy life insurance policies on the lives of each co-owner (but not on themselves). If you were to die, the policyowners (the company or co-owners) receive the death benefits from the policies on your life. That money is paid to your surviving family members as payment for your interest in the business. If all goes well, your family gets a sum of cash they can use to help sustain them after your death, and the company has ensured its continuity.

Advantages of using life insurance

• Life insurance creates a lump sum of cash to fund the buy-sell agreement at death
• Life insurance proceeds are usually paid quickly after your death, ensuring that the buy-sell transaction can be settled quickly
• Life insurance proceeds are generally income tax free; a C corporation may be subject to the alternative minimum tax (AMT)
• If sufficient cash values have built up within the policies, the funds can be accessed to purchase your business interest following your retirement or disability

Disadvantages of using life insurance

• Life insurance premiums are paid with after-tax dollars because the premiums are generally not a tax-deductible expense
• Premium requirements are an ongoing expense
• One or more co-owners may be uninsurable due to age or illness
• If the co-owners’ ages vary widely, younger co-owners will have to pay higher premiums on the lives of the older co-owners
• If the ownership percentages vary widely, more insurance will be needed to cover the owners with the larger ownership interests, resulting in higher premium costs for those with smaller ownership interests

How to set up different types of buy-sell agreements

In an entity purchase buy-sell agreement, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and is the owner and beneficiary of the policies.

In a cross purchase buy-sell agreement, each co-owner buys a life insurance policy on each of the other co-owners. Each co-owner usually pays the annual premiums on the policies they own and are the beneficiaries of the policies. If your company has a large number of co-owners, multiple policies must be purchased by each co-owner.

A wait and see (or hybrid) buy-sell agreement allows you to combine features from both the entity purchase and cross purchase models. The business can buy policies on each co-owner, the individual co-owners can buy policies on each other, or a mixture of both methods can be used.

The buy-sell agreement should be fully funded

The amount of insurance coverage on your life should equal the value of your ownership interest. Then, when you die, there will be enough cash from the policy proceeds to pay your family or estate in full for your share of the business. But if all that is affordable is insurance coverage for a portion of your interest, you might want to go ahead and fund that amount. Later, the company may be able to increase the amount of insurance or use additional funding methods. In the meantime, the agreement should specify how your family or estate will be paid.

The value of the business could change over time

What if the insurance proceeds turn out to be less than the value of your business interest, due to growth in the business? Your surviving family members might end up getting less than full value for your business interest. Your buy-sell agreement should specify how the valuation difference will be handled.

Conversely, the insurance proceeds might be greater than the value of your business interest when you die. Your buy-sell agreement should address this potential situation upfront and specify whether the excess funds will belong to the business, the surviving co-owners, or your family or estate.

Should group life insurance be used?

Using a company’s group life insurance plan to fund a buy-sell agreement is generally not recommended. Normally, group life insurance premiums are tax deductible to the company. But premiums are no longer deductible if the business is the beneficiary.

Possible negative tax consequences

• For policies issued after August 16, 2006, the death benefits of life insurance on the life of an employee payable to the employer/policy owner may be subject to income taxes unless an exception applies.
• Assume your business is a corporation or is taxed as one. When one of your co-owners dies, his or her estate becomes the owner of the insurance policies covering you and the other co-owners of the business in a cross purchase agreement. If these policies are then transferred to the surviving co-owners to pay for future buyouts, a transfer-for-value (gain) may occur, and a portion of the proceeds received from the transferred policies may be taxable.
• If a policy is canceled (surrendered) for cash to buy out your interest while you are living, any gain on the policy is subject to federal income tax for the policyowner. Gain includes all policy loans outstanding at the time of surrender. Also, the policy may carry surrender charges.
• The proceeds received by a C corporation under an entity purchase agreement may be subject to the AMT.

Keeping track of your buy-sell agreement

Each year, the premiums on the policies must be paid, or the insurance will lapse. So monitor premium payments carefully. Your buy-sell agreement should include a feature requiring ongoing proof of payment. Also, review the amount of insurance regularly. The insurance coverage may have to be increased periodically to reflect increases in the value of the business. If additional insurance is not possible, another funding method should be established. Finally, periodically check the financial rating of your insurance company. The policies funding your buy-sell agreement will do your family no good if the insurer becomes insolvent.

Funding a Buy-Sell Agreement with Disability Insurance

You may have a great buy-sell agreement in place at the company where you are a partner or co-owner–one that clearly stipulates how much your family will be paid for your share of the business interest in the event of your death. It may also cover early retirement and the buyout terms under those circumstances. But what if you become disabled long before you are likely to die or retire? Insurance industry statistics show that the chance of you or one of your co-owners sustaining a long-term illness or injury (over one year) before age 65 is much greater than the odds of any one of you dying prematurely. Disability income insurance may provide a solution.

How disability income insurance works

If you were to suffer a severe injury or develop some type of long-term illness, you would probably be unable to earn a paycheck during that time. Disability income insurance is a salary-continuation agreement that replaces a portion of your income while you are injured or ill. Disability insurance with your buy-sell agreement provides the funds to allow your company to continue paying your salary or to completely buy your share of the business if your disability is permanent.

Keep in mind that disability insurance is designed to protect you in the event of a long-term illness or injury. So, a disability insurance policy includes an elimination period (i.e., a waiting period between the time you become sick or injured and the time any benefits are paid). Some policies call for waiting periods as long as one or two years, so you will need to depend on your savings and other investments for a considerable period of time. Depending on the type of policy, you can receive benefit payments in either a lump sum, installment payments, or a combination of the two. Disability insurance should generally be used in addition to the funding method you have chosen for the purchase of your business interest at your death or retirement.

Coordinate the disability policy with your buy-sell agreement

You should make sure that any conflict between the provisions of your disability income insurance policy and your buy-sell agreement is eliminated at the outset. The buy-sell agreement should contain the same definition of disability as your disability policy. Determine when the agreement requires a complete buyout after you become sick or injured. Also, coordinate the waiting period, how benefits are paid, and how you may be able to buy your shares back if you recover from your illness or injury.

Different types of buy-sell agreements

If your buy-sell agreement is an entity purchase (stock redemption) plan, the company itself buys disability policies for each of the shareholders or partners. The company is the owner, premium payer, and beneficiary of the policies. With a cross purchase (crisscross) agreement, you and your co-owners agree as individuals to purchase the business interest of any co-owner who becomes disabled. Under the terms of the agreement, you buy a separate disability policy on each of the other co-owners; in turn, each co-owner buys a policy on you. Each of you is the owner, premium payer, and beneficiary of the policies you have purchased. Be aware that tax consequences may arise if the company pays the premiums on policies under a cross purchase agreement. A wait and see (hybrid) buy-sell agreement allows you to combine features of both an entity purchase and cross purchase agreement.

Disability income funding can ensure you a fair price

The greatest advantage offered by using disability insurance with your buy-sell agreement is that you can receive the full value of your business interest if you become disabled before your death or normal retirement. For example, say you become permanently disabled in an auto accident. You are unable to work and want to sell your interest in the business you helped establish, but the company doesn’t have the cash to pay you right now. Without disability coverage in this circumstance, you might be forced to go outside the company to sell your business interest. You could end up selling the interest for less than it is worth.

Funding your buy-sell agreement with disability insurance assures that the other co-owners will buy your interest, names the conditions under which they will purchase your interest, and provides the money to pay you a fair price. If your injury is not permanent, disability insurance will provide income protection for your family while you are recovering.

What are the drawbacks of using disability insurance?

• Insurance premiums are not tax deductible. It makes no difference if the payments are made by the business itself or the individual owners.
• Insurance companies may consider you uninsurable–ineligible for disability insurance–due to factors such as your age, health problems, high-risk hobbies, or employment in certain occupations.
• Disability insurance can be used only if you’re sick or injured. There is no policy benefit available if you die or retire from the business when you’re healthy.

What happens if you recover from your disability?

It’s possible that you could recover from your illness or injury after you’ve already sold your business interest under your buy-sell agreement’s disability clause. If this happens, you could find yourself without a business, career, or income. Make sure that your buy-sell agreement addresses whether you’ll be eligible to buy your shares back if you recover after the waiting period. The agreement should contain a schedule specifying how your interest will be transferred back to you. Because it is possible that you’ll recover from your disability, it is generally advisable to set up a long waiting period before the policy pays salary continuation benefits or triggers the purchase of your share of the company. This reduces the chance that you may recover from your disability after having sold your business interest. In addition, longer waiting periods reduce the policy premiums.

Monitoring your buy-sell agreement

Remember that the disability insurance with your buy-sell agreement will provide you with no benefit if the policy is allowed to lapse. Make sure that all required premiums are regularly paid. You don’t want to leave yourself and your family unprotected at a time when you’re sick or injured. While you’re at it, check up on the other funding components of your buy-sell agreement. And if the agreement is not fully funded, push to have this done as soon as it is financially feasible for the company. Finally, as the company grows, it’s important to periodically review the buy-sell document and the funding vehicles to ensure that they’re keeping pace with the current value of your business.

Business Succession Planning Alternatives

 

Lifetime gifts Bequest Lifetime sale Estate sale Buy-sell agreement If you want to: Sell your business interest Not appropriate Not appropriate You may be able to sell your business outright-but there is no guarantee Your estate may be able to sell your business outright-but there is no guarantee Buy-sell agreement can be used to guarantee the sale of your business If you want to: Give business to your children You can control the timing and size of the gifts You control the size of the gift through your will Not appropriate Not appropriate Not appropriate If you want to: Sell business to your children Can be used in conjunction with sale Not appropriate You can control timing of sale-but sale is not guaranteed Your child could buy from your estate-but sale is not guaranteed Buy-sell can be used to guarantee your child’s option to buy your interest If you want to: Minimize value of your estate Can be used to reduce the value of your estate and maximize gift tax exclusion Will not minimize value of your estate You can control timing of sale-but sale is not guaranteed Value of business must be included in your estate Value of business must be included in your estate, but the buy-sell can help establish that value

Select Options for Preserving a Family Business for Children

Overview of Buy-Sell Agreement Forms

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Wait and See

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Section 303 Stock Redemption

Nineteen questions you should consider when choosing a buy-sell agreement

 

Factors to consider	Cross Purchase	Entity Purchase	Section 303 Stock Redemption
What is the form of business entity?	Any business with multiple owners	Any business with multiple owners	Any business with multiple owners especially family corporation
Who is the buyer?	Co-owner	Business entity	Business entity
Who is the seller?	Shareholder or family or estate of shareholder	Shareholder or family or estate of shareholder	Family or estate of shareholder
Can life insurance be used to fund agreement?	Yes, generally each shareholder is applicant, owner, payor and beneficiary of life insurance on other shareholders	Yes, generally business entity is applicant, owner, payor and beneficiary of life insurance on each shareholder	Yes, business could be applicant, owner, payor, and beneficiary of life insurance on each shareholderIn family corporation family members could own policy
How many policies will be needed?	Multiple policies neededFormula used is: n(n-1) n = number of shareholders	Number of policies is minimalOnly one policy per shareholder needed	Number of policies is minimalOnly one policy per shareholder needed
Are the premiums deductible?	Premiums are not tax-deductible expense to shareholders	Premiums are not tax-deductible expense to corporation	Premiums are not tax-deductible expense to business or family member
Are death proceeds taxable?	Received by surviving shareholders tax free	Received by business entity tax freeAlternative Minimum Tax (AMT) may apply	Received by business entity tax freeAlternative Minimum Tax (AMT) may apply
Are death proceeds subject to claims of creditors?	In most states, death proceeds on personally owned policies are exempt from claims of creditorSome states limit amount of proceeds exempted	Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business	Corporate creditors can’t reach proceeds of personally owned policies, but they can claim against proceeds of life insurance owned by the business
Does business have a right to death proceeds?	Proceeds available to business only if surviving shareholders willing to make loan or capital contribution	Business entity has right to death proceeds when it is policy beneficiary	Business entity has right to death proceeds when it is policy beneficiaryProceeds payable to family available to business only if family member willing to make loan or capital contribution
What happens to stock basis of remaining shareholders?	Basis increases by amount equal to price paid by shareholder for stock	No increase in shareholder’s basisValue of stock owned by remaining shareholders increases when corporation retires stock or holds as treasury stock	No increase in shareholder’s basisValue of stock owned by remaining shareholders increases when corporation retires stock or holds as treasury stock.
What if co-owners are related and business is a corporation?	Not an issue	Attribution rules apply when stock purchased by business entityIn family corporation redemption of stock usually results in dividend	Attribution rules specifically do not apply to this type of transaction
What if there is a need to change from one type of insurance funded buy-sell to another?	Transfer of existing insurance policies to corporation may be an exception to Transfer-for-Value Rule	Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies	Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies
Which plan has most flexibility?	Agreement with multiple shareholders can be cumbersome when funded with life insuranceAdding new shareholders to plan may be complicated	Can’t be used by a corporation with only one shareholder or a sole proprietorshipCan add new shareholders to plan with unanimous consent to amend agreement	Authorizes partial redemption of decedent’s stock with favorable tax treatmentAmount of stock redeemed is limited
Is value of insurance included in estate of decedent shareholder?	Value of policies owned on other shareholders included in estateProceeds of policies on own life are generally not included in estate	Value of proceeds payable to business may indirectly increase decedent’s estate by increasing the value of corporation	Value of proceeds payable to business may indirectly increase decedent’s estate by increasing the value of corporation
Are ownership amounts or percentages affected?	Remaining shareholder’s ownership percentages can remain same or change, depending on amount of stock purchased by each	Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity	Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity
Does state law apply?	If professional corporation state law restricts sale to other professional	State corporate law allows a corporation to buy its own shares only from surplus fundsRedemption prohibited if would make a corporation insolvent	State corporate law allows a corporation to buy its own shares only from surplus fundsRedemption prohibited if would make a corporation insolvent
Could there be a problem when transferring the policies which decedent owned on surviving shareholders?	Potential Transfer-for-Value problem at shareholder’s death when decedent’s interest in policies is transferred to surviving shareholders	If policies are owned by corporation, there is no need to transfer at decedent’s death	If policies are owned by corporation, there is no need to transfer at decedent’s death
What happens if business earnings accumulate to fund buy-sell?	No corporate funds usedUsually no Accumulated Earnings Tax issue	Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven	Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven
Are there any estate tax effects to shareholder?	If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposesSale price included in estate	If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposesSale price included in estate	If estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposesSale price included in estate

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Trusteed Cross Purchase

Nineteen questions you should consider when choosing a buy-sell agreement

Buy-Sell: Cross Purchase vs. Entity Purchase vs. One-Way

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Section 302 Stock Redemption

Nineteen questions you should consider when choosing a buy-sell agreement

 

Factors to consider	Cross Purchase	Entity Purchase	Section 302 Stock Redemption
What is the form of business entity?	Any business with multiple owners	Any business with multiple owners	Any business with multiple owners
Who is the buyer?	Co-owner	Business entity	Business entity
Who is the seller?	Shareholder or family or estate of shareholder	Shareholder or family or estate of shareholder	Shareholder or family or estate of shareholder
Can life insurance be used to fund agreement?	Yes, generally each shareholder is applicant, owner, payor and beneficiary of life insurance on other shareholders	Yes, generally business entity is applicant, owner, payor and beneficiary of life insurance on each shareholder	Yes, business entity could be applicant, owner, payor, and beneficiary on policy on life of seller
How many policies will be needed?	Multiple policies neededFormula used is: n(n-1) n = number of shareholders	Number of policies is minimalOnly one policy per shareholder needed	Number of policies is minimalOnly one policy per shareholder needed
Are the premiums deductible?	Premiums are not tax-deductible expense to shareholders	Premiums are not tax-deductible expense to business	Premiums are not tax-deductible expense to business
Are death proceeds taxable?	Received by surviving shareholders tax free	Received by business entity tax freeAlternative Minimum Tax (AMT) may apply	Received by business entity tax freeAlternative Minimum Tax (AMT) may apply
Are death proceeds subject to claims of creditors?	In most states, death proceeds on personally owned policies are exempt from claims of creditorSome states limit amount of proceeds exempted	Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business	Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business
Does business have a right to death proceeds?	Proceeds available to business only if surviving shareholders willing to make loan or capital contribution	Business entity has right to death proceeds when it is policy beneficiary	Business entity has right to death proceeds when it is policy beneficiary
What happens to stock basis of remaining shareholders?	Basis increases by amount equal to price paid by shareholder for stock	No increase in shareholder’s basis.Value of stock owned by surviving shareholders increases when corporation retires stock or holds as treasury stock	No increase in shareholder’s basis.Value of stock owned by surviving shareholders increases when corporation retires stock or holds as treasury stock
What if co-owners are related and business is a corporation?	Not an issue	Attribution rules apply when stock purchased by business entityIn family corporation redemption of stock usually results in dividend	Attribution rules apply when stock purchased by business entityIn family corporation redemption of stock usually results in dividend
What if there is a need to change from one type of insurance funded buy-sell to another?	Transfer of existing insurance policies to corporation may be an exception to Transfer-for-Value Rule	Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies	Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies
Which plan has most flexibility?	Agreement with multiple shareholders can be cumbersome when funded with life insuranceAdding new shareholders to plan may be complicated	Can’t be used by a corporation with one shareholder or a sole proprietorshipCan add new shareholders to plan with unanimous consent to amend agreement	Can’t be used by a corporation with one shareholder or a sole proprietorshipCan add new shareholders to plan with unanimous consent to amend agreement
Is value of insurance included in estate of decedent shareholder?	Value of policies owned on other shareholders included in estateProceeds of policies on own life are not included in estate	Value of proceeds payable to business may indirectly increase decedent’s estate by increasing the value of corporation	Value of proceeds payable to business may indirectly increase decedent’s estate by increasing the value of corporation
Are ownership amounts or percentages affected?	Remaining shareholder’s ownership percentages can remain same or change, depending on amount of stock purchased by each	Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity	Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity
Does state law apply?	If professional corporation state law restricts sale to other professional	State corporate law allows a corporation to buy its own shares only from surplus fundsRedemption prohibited if would make a corporation insolvent	State corporate law allows a corporation to buy its own shares only from surplus fundsRedemption prohibited if would make a corporation insolvent
Could there be a problem when transferring the policies which decedent owned on surviving shareholders?	Potential Transfer-for-Value problem at shareholder’s death when decedent’s interest in policies is transferred to surviving shareholders	If policies are owned by corporation, there is no need to transfer at decedent’s death	If policies are owned by corporation, there is no need to transfer at decedent’s death
What happens if business earnings accumulate to fund buy-sell?	No corporate funds usedUsually no Accumulated Earnings Tax issue	Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven	Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven
Are there any estate tax effects to shareholder?	If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposesSale price included in estate	If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposesSale price included in estate	If estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposesSale price included in estate

Comparison of Buy-Sell Funding Methods

Funding Method	Seller Advantages	Seller Disadvantages
Lump-Sum Cash	Seller gets money up front	Seller may not get money if buyer doesn’t have it
Private Annuity	Often used in family transfersCan lower seller’s estate value	Seller becomes unsecured creditor of buyer
Borrowings	Seller gets money up front	Seller may not get money if buyer doesn’t have access to credit
Installment Payments	Seller can set favorable interest rateGain can be spread over time	Seller becomes creditor of buyer
Sale-Leaseback	Seller gets money up front	No guarantee sale-leaseback transaction will occur
Section 303 Stock Redemption	Seller receives cash for estate settlement	Seller not guaranteed cash–company may not be able to redeem stock under local law
Deferred Compensation	Seller receives payments beginning at retirement or withdrawal	Business may not be able to make payments
Appreciated Property Bailout	Seller receives asset in exchange for stock	Seller does not receive cash
Life Insurance	Seller gets money up front	Seller may be uninsurable
Disability Insurance	Seller can “cash out” of business after disability	Seller may be uninsurableSeller could recover from disability, no longer have a business

Beneficiary Designations for Buy-Sell Agreements Funded with Life Insurance

The general rule is that the party with the obligation to make the purchase of the business interest at an owner’s death is the party that should be the beneficiary of the funding life insurance policy. As such, the logical beneficiaries for each form of buy-sell agreement are shown below.

 

Surviving spouse/heir Business entity Buyer Seller’s estate Trustee Entity purchase agreement No Logical No No Can be used, but not common Cross purchase agreement No No Logical No If a trusteed cross purchase Trusteed cross purchase No No No No Logical Wait and see agreement No Maybe Maybe No Maybe Section 302 stock redemption No Logical No No No Section 303 stock redemption Maybe Logical No No No Reverse Section 303 redemption Logical No No No No

Planning for Succession of a Business Interest

Cross Purchase: During Lifetime

Cross Purchase: At Death

Entity Purchase Buy-Sell: During Lifetime

Entity Purchase Disability Buyout: During Lifetime

Wait and See Buy-Sell: During Lifetime

Wait and See Buy-Sell: At Death

Business Valuation Diagram

Rolling GRATs

Can I transfer my business through my will?

Yes, you can use your will to transfer your business interest after your death. You can also use your will to specify a long-term succession plan for your business if, for instance, you want one of your children (who may be currently active in the business) to take over and run it when you’re gone. Without such a clause in your will, your interest could possibly be distributed equally to all of your children, even though you did not intend that result.

A disadvantage of transferring your business through your will is that the full value of your interest will be included in your taxable estate. Unless you have made provisions for additional liquidity (e.g., by using life insurance), your heirs may be forced to sell the company just to pay the estate taxes.

Assets disposed of through a will are subject to probate, the court-supervised process of administering a will. Probate can be expensive and time consuming. It could also result in business interruptions, which in turn could result in a loss of customers and employees if confusion develops over who’s running the business and how it will continue to operate. The probate process is also public, which may allow others to discover details about your estate that you would rather not disclose.

Talk to your lawyer and your financial professional about your business interest and what you would like to happen to it at your death. Transferring your interest through your will is just one method that can be used. Other options (or combinations of options) can also be used to accomplish your wishes. Some methods may allow you to equalize distributions to your heirs without splitting up the business. Some can help you minimize the taxable value of your business interest. A buy-sell agreement can be drafted now to establish a plan for the future succession of your business interest. Trusts may also be used to help accomplish your goals. All of these strategies take time to plan and implement, so the best time to begin planning is now.

What is a buy-sell agreement?

A buy-sell agreement is a contract that provides for the future sale of your business interest or for your purchase of a co-owner’s interest in the business. Buy-sell agreements are also known as business continuation agreements and buyout agreements.

Under the terms of a buy-sell agreement (assuming you are the seller), you and the buyer enter into a contract for the transfer of your business interest by you (or your estate) at the occurrence of a specified triggering event. Typical triggering events include death, disability, and retirement.

Ideally, buy-sell agreements are fully funded, and life insurance is frequently used for this purpose. After determining the value of the business, you, your advisors, and the other parties to the agreement will determine the best way to fund the transaction, and the triggers appropriate for your business situation.

If you own a business and are concerned about how the death of a co-owner might affect its operation, a funded buy-sell agreement can help by ensuring that you will be able to purchase your partner’s share, eliminating any doubts about the continuation of the business. You can also avoid the dilemma of being in business with your partner’s survivors.

There are also costs and possible disadvantages involved in establishing a buy-sell agreement. One such disadvantage is that the agreement typically limits your freedom to sell the business to outside parties. If you think that a buy-sell agreement might benefit you and your business, consult your attorney and financial professional about the pros and cons of setting one up.

How can I determine what my business is worth for estate and gift tax purposes?

Determining the value of your business is something you should not attempt to do on your own, especially because the IRS could challenge your valuation. Even the IRS acknowledges that no one true fair market value (FMV) exists for a closely held business. There are appraisers who specialize in determining the value of businesses. Your CPA may be one of these specialists or know someone who is.

FMV is defined by the federal estate and gift tax regulations as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” It is the sale price that a hypothetical buyer and seller would reach, not necessarily the price that the actual owner would agree to or the price that an actual buyer might be willing to pay.

You may have had your business appraised in the past for another purpose. As tempting as it might be, don’t use an old appraisal for a new transaction. The purpose of the appraisal can affect the valuation assigned, and time can change the factors that go into the appraisal calculation.

Numerous factors might affect the value of a business. However, the IRS has identified a number of relevant considerations:

• Nature of the business and history of the company
• Outlook for the economy in general and an industry in particular
• Book value and financial condition of the company
• Earnings capacity
• Dividend-paying capacity
• Goodwill/intangible value
• Sales of stock and the size of block to be valued
• Market value of stock in comparable businesses

A number of different methods exist for determining the FMV for a closely held business. Generally, only an appraiser will know how to analyze these factors to reach a conclusion as to the FMV of your business.

How can I keep my business in the family?

What is a family limited partnership, and will it help reduce estate taxes?

A family limited partnership (FLP) is a partnership created and governed by state law and generally comprises two or more family members. As a limited partnership, there are two classes of ownership: the general partner(s) and the limited partner(s). The general partner(s) has control over the day-to-day operations of the business and is personally responsible for the debts that the partnership incurs. The limited partner(s) is not involved in the operation of the business. Also, the liability of the limited partner(s) for partnership debts is limited to the amount of capital contributed.

An FLP can be a powerful estate planning tool that may (1) help reduce income and transfer taxes, (2) allow you to transfer an ownership interest to other family members while letting you keep control of the business, (3) help ensure continued family ownership of the business, and (4) provide liability protection for the limited partner(s).

An FLP is often formed by a member(s) of the senior generation who transfers existing business and income-producing assets to the partnership in exchange for both general and limited partnership interests. Some or all of the limited partnership interests are then gifted to the junior generation. The general partner(s) need not own a majority of the partnership interests. In fact, the general partner(s) can own only 1 or 2 percent of the partnership, with the remaining interests owned by the limited partner(s).

There are several advantages to organizing your business as an FLP:

• Limited partnership interests that are gifted to other family members are generally valued at less than the full fair market value of the underlying assets. That is, reasonable discounts to the value of the limited partnership interests are permitted for lack of marketability and lack of control. This means that by gifting the assets via a limited partnership interest instead of an outright transfer of the business assets themselves, you may be saving gift and estate taxes.
• At death, only the value of your ownership interest in the partnership will be included in your gross estate.
• The use of the partnership entity allows you to shift some of the business income and future appreciation of the business assets to other members of your family.
• You maintain management control of the business while transferring limited ownership of the business to family members.
• Restrictions within the partnership agreement limiting the transfer of the partnership interests may help ensure continuous family ownership of the business.

I own a business. Are there any creative ways I can use life insurance in my business?

You can use life insurance in several ways to help your business.

You might consider purchasing a key-person life insurance policy that covers the loss of services when a key employee or partner dies. The benefits can be used to cover any lost profit and the cost of replacing the employee or partner. The insurance is owned by your business, which also receives the benefits.

Another way to insure against the death of a business partner is through a buy-sell agreement. For example, three partners in a business each own the same amount of stock. One partner, Mr. Clark, dies, and his stock goes to his wife through his will. If the business had written a buy-sell agreement and funded it with life insurance, the surviving partners would have received a life insurance benefit when Mr. Clark died. The partners and Mrs. Clark could then have exchanged the life insurance benefit for the company stock.

Split-dollar life insurance is another benefit you can offer your employees while investing in your company. Here, the business purchases a life insurance contract on the life of an employee and shares the cost. If the employee dies, your business receives an amount equal to the premiums paid, and the employee’s beneficiary receives the remaining death benefit. If the policy is surrendered for any other reason, your business receives the cash value.

Deferred compensation that supplements a retirement plan is another option you might consider. Your company would buy a life insurance policy on the life of a key employee. The business is the owner and beneficiary. If the employee dies, the business receives the death benefit tax free. From the benefit proceeds, your business pays an annual sum to the employee’s survivors for a specified period.

Providing group life insurance as an employee benefit can also help your business by attracting and retaining employees. Group insurance is less expensive to purchase than individual insurance. Also, no medical exam may be required, depending on the size of your company. Here, the premiums are tax deductible to your business, and the benefits are paid directly to your employee’s beneficiary.