Preparing for the Worst
An updated buy-sell policy is a must because in business - as in life - there's no tellinbg how the cards will fall
BY FRANK JOSSI
A few years ago, two business owners came to Jim Peterson to have the insurance expert look over their company’s buy-sell arrangement. To fund the buyout in case of an untimely death, each owner had purchased a $1 million life insurance policy on himself that named the other owner as the beneficiary.
It’s a common enough arrangement among business partners who want to help one another buy the business in the case of a death. The big problem in this case, recalls Peterson, CEO and owner of St. Paul-based Aware Financial LLC, was that the business had become hugely successful and worth more than $30 million. The buy-sell agreement the owners had written years ago required the surviving owner to purchase the deceased owner’s shares for cash in just 90 days.
To make matters worse, the cross-ownership of the policies would make the death benefit taxable even though life insurance proceeds are generally income tax-free. “This would leave about $600,000 of the $1 million death benefit after taxes and the remaining owner would have 90 days to come up with an additional $14.4 million in cash to satisfy the buyout obligation,” says Peterson. “What we like to see in an agreement is that the purchase price is to be paid in cash to the extent there’s insurance and then after that, if insurance doesn’t cover the whole price, the balance can be paid in installments.”
Welcome to the world of buy-sell agreements, a governing document for closely held corporations that carries implications for everything from estate plans to business succession arrangements, from insurance decisions to personal wealth management. A company without a buy-sell could face enormous tax liabilities and potentially fractured management in the future. For firms with older agreements, the key is updating the document, especially if the entity’s value has grown considerably.
THE IMPORTANCE OF BUY-SELL
Do all owners have a buy-sell agreement? Not always, and for good reason.
“Business owners often don’t have an agreement because they’re busy people,” says William P. Ringham, wealth strategy senior manager at RBC Wealth Management. “Taking time out to get this process done is not the first and foremost thing they’re working on. They’re making sure the business is doing well and doing what they’re supposed to be doing to continue to succeed and grow that business. You sit down with partners who don’t have agreements who have a pretty successful operation going who say ‘look at what we’ve built’ and they don’t have anything on paper.”
Buy-sell planning may sound about as interesting an exercise as watching infomercials, but in reality it is strategically important to a business. “Buy-sell is something business owners just don’t want to deal with; it’s out of sight, out of mind,” says Kate Kelly, president and CEO of Minnesota Bank & Trust in Edina. “Many owners may have started their businesses 10 or 20 years ago and since then so many things have changed in this arena, and their policies are not in good shape.”
A buy-sell policy 10 years old, or even five years old, is probably not the best vehicle for insuring a partner. The valuations and insurance policies conceived at the time the business began are unlikely to reflect the cost of doing business in the market today. “You want to make sure the policies are good,” she says. “You have to take care of your family and take care of what you have in your partnership agreement. It is important to make sure things are up to date in case something were to happen.”
Business consultants understand how expensive and difficult it can be for companies who suffer a tragedy without a buy-sell in place. “When a partner dies in an accident, if the company he works for does not have a buy-sell in place, it is possible to see a great deal of money spent by the company and by the family of the deceased on attorney’s fees,” says Tom Lyons, president of Faelon Partners and author of “Exit Strategy: Maximizing The Value of Your Business.”
CREATING THE AGREEMENT
Businesses should see buy-sell plans as equivalent to “prenuptial agreements” that are better done early in a business, when everyone is friendly. “A departure may not be that friendly—very often it isn’t,” says Ron Overson, a partner with Boulay Heutmaker Zibell & Co.
Buy-sell planning defines several things, including how compensation will work when a shareholder leaves, dies, retires or is terminated, says Overson. Shareholders have to agree in a buy-sell on a methodology for determining a valuation when a situation with a shareholder arises. The plan will outline the process for redeeming shares. A common approach might be 20 percent down, the balance to be paid over five years along with a pre-determined interest rate, he says.
The buy-sell will address a disability one of the partners may incur during the life of the company. A clause will set up a system for paying a partner with a disability for a set number of months before a decision is made to buy that individual out if the health issue continues.
A buy-sell will spell out the terms for firing a partner, as well as the compensation the terminated employees will receive. “Partners are fired more often than you’d think,” says Overson.
Agreements might also contain provisions for family members to inherit a business owner’s portion of the company. Sons or daughters may want to inherit a parent’s portion of a business and that desire needs to be written into a buy-sell or remaining partners could conceivably terminate them, according to Peterson.
Another aspect of buy-sell deals with noncompete clauses. To avoid having shareholders leave to start new and competing businesses down the block, most companies have non-compete clauses prohibiting key shareholders from joining a competitor, or starting a business, within a certain geographic area for a time period of one to two years, says Overson. “It has to be a reasonable length of time and within a reasonable geographic area,” he says. “It may be difficult to stop someone from competing for 18 years anywhere in the country. But it’s an important document to have.”
The two most popular methods of funding buy-sell arrangements are cross-purchase or stock redemption agreements. They have their advantages and disadvantages but most consultants believe life insurance works better than anything else for funding a buy-sell. “It’s probably a more cost-effective and guaranteed form of liquidity you can have at the time you need it,” says Ringham. “That’s why a lot of people do use insurance to fund the buy-sell. It’s the most cost-effective way for people to buy deceased partners out of their estates.”
THE AGREEMENTS
Cross-purchase policies, where partners buy policies and make one another beneficiaries, are popular means to fund buy-sell agreements. They offer quick liquidity for remaining partners to buy out shares and satisfy the family of the deceased. It’s a clean break, in effect, if the insurance is high enough to pay off the shares the deceased owned in the private company.
A cross-purchase buy-sell arrangement also increases the tax basis for the surviving partner should the business be sold in the future. If an owner with a cross-purchase agreement receives a $2.5 million insurance policy payment and pays it to purchase the shares from the deceased owner’s estate, then the surviving owner will receive a $2.5 million dollar tax basis increase. “What life insurance does is increase the basis for calculating taxes in the event of a sale by the surviving partner,” says Peterson.
If a company has several partners buying life insurance, a cross-purchase plan probably isn’t going to work, says Ringham. Six co-owners would require an onerous 30 policies, with each owner having a policy on every other owner. That’s a recipe for confusion and extra cost, he says.
A more likely option for these companies is a stock redemption plan. In this kind of plan the corporation holds the policies of the shareholders. If a shareholder dies, the corporation cashes in the policy and uses that to buy the individual’s interest, says Overson. The issue with stock redemption plans comes down, once again, to tax matters that should be taken into account before using it as the means of a buy-sell agreement.
A third option some business owners have used is a wait-and-see buy-sell arrangement. Shareholders have the opportunity to buy from the estate of a deceased shareholder and to the extent that the surviving owners don’t purchase all the shares from the estate, the corporation must redeem them. Or, shareholders short on funds could skip insurance all together and invest in raising their corporate profits, betting they can beat returns offered by life insurance policies.
The decision of which plan to choose involves a good business attorney and accountant who can study the tax implications and assist companies in making the appropriate choice, says Lyons. Despite the cost involved in setting up a buy-sell, even cash-poor startups should consider doing it immediately. “It’s money that needs to be spent,” he says. “You need to get a good document for working with trusted partners.”
Peterson solved the problem of his underinsured business owners by increasing the amount of insurance on each owner and adding an installment plan strategy should a partner die. Fortunately, neither owner has passed away. They remain business partners and friends.