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If you own and manage a business, what will happen to that business, especially the day-to-day operations, when you pass on or suddenly become incapacitated? It’s understandable if you feel somewhat uncomfortable contemplating your death or unexpectedly succumbing to a health condition that leaves you incapacitated.
Nevertheless, it is critically important to have a succession plan in place so you, your business associates and family members understand what to do in the event you pass away. In addition, an often-overlooked component of a business succession plan is a sufficient life insurance policy. In fact, an adequate life insurance policy could mean the difference between your small business, such as an LLC, surviving and thriving in the wake of your death or being forced to shutter and close.
It’s important to highlight the benefits of incorporating life insurance into a business succession plan, because experience shows that many business owners are neglecting this valuable succession tool. In fact, only 20% of small business owners currently have business life insurance, and only 18% of owners have a business disability insurance policy, according to the Life Insurance Marketing and Research Association.
A sufficient life insurance policy can be an extremely valuable component in a business succession plan. When structured properly, a life insurance policy can provide income tax dollars that can be used in numerous ways. For example, it is fairly common to find provisions within LLC operating agreements and buy-sell agreements that obligate the surviving owners to purchase the membership interest of a deceased member/owner. As a result, it is extremely important to have access to the necessary liquidity to complete this transaction and ensure the business is able to run effectively. This is why it is fairly common for the founding members/owners of an LLC to take out life insurance policies on each other. This is because death is typically a triggering event that activates the purchase provision of a buy-sell agreement into effect.
Here is an example of how life insurance could provide to be invaluable in the context of a multi-member LLC – two friends decide to form an LLC that would focus on investing in rental properties. One of the members opts to focus on handling the operational aspects of the LLC. The other member opts to focus on the maintenance aspect of the rented properties. Let's say the member who focused on maintenance was suddenly killed in a car accident. In the wake of this tragedy, the surviving member of the LLC now needs to find someone who is capable of handling home repairs. In addition, the decedent's surviving spouse who assumed the ownership interest in the LLC wants to be bought out. This is where a sufficient life insurance policy can prove to be invaluable since the proceeds could be used to hire a new maintenance worker and help facilitate the buyout of the decedent's surviving spouse.
If you own and operate a family-run business, it is fairly common for not all of your children to be capable or even interested in assuming ownership of the business when you pass away, or were to suddenly become incapacitated. Nevertheless, if you have a succession plan in place where the family-run business passes on to your children who have actually expressed interest and are active in the operations of the business, an important question needs to be answered – what about the other children? Well, a business owner can utilize the proceeds of their life insurance policy to provide for those children who are not involved in the business to help “equalize” their overall estate.
For many small business owners, particularly family-run business owners, the business itself is the largest asset in their estate. When you have a sufficient life insurance policy, the proceeds can be used to provide the necessary cash to pay any federal and/or state-level estate taxes. Life insurance proceeds can be extremely valuable since there are instances where the value of a business cannot be quickly liquidated to pay various costs and potential taxes.
When a small business owner begins the transition of their ownership interest and day-to-day management of the business, it is extremely important to attract and retain long-time employees with institutional knowledge. In this instance, compensation and incentive plans can help increase the probability of these long-time employees remaining within the business. A sufficient life insurance policy can be a helpful vehicle for informally funding these compensation and incentive plans because they offer tax-deferred cash value growth and tax-free death benefits.
The concept of business succession planning is oftentimes referred to as “business continuation planning.” It is considered to be the process of establishing objectives and desires of the business owner, or owners, when it comes to determining who will assume the ownership and management of their business interest.
A properly structured business succession plan needs to address various issues and contingencies, including:
Basically, a detailed business succession plan should be the blueprint that sets forth the protocol for a smooth, efficient transition of the management and ownership of a business. The importance of a business succession plan extends to all types of business, including small businesses such as LLCs, partnerships and family-run businesses.
When crafting a business succession plan, you should emphasize transparent communication of the overall strategy to key individuals within the business, along with family members. If you are transparent with these individuals, it will help reduce the risk of disagreements or unexpected issues in the event of your death or disability. You also need to be vigilant and review the business succession plan to ensure the details remain current and relevant.
Life insurance can be an effective tool that you can utilize to help provide necessary liquidity to meet the obligations set forth in a buy-sell agreement (more on this topic below).
It is extremely important for a business succession plan to have a detailed buy-sell agreement in place. A buy-sell agreement is a legally enforceable contract that addresses many of the “what ifs” that may threaten the ongoing operations of a business. A detailed buy-sell agreement should be comprehensive and consider a plethora of legal and tax-related issues. The overarching objective of this buy-sell agreement is to outline and detail, in advance, what is going to occur in the event of the death, disability or retirement of a business owner or a business owner opts to sell their interests.
For small business owners, having a succession plan in place is critically important to help improve the likelihood that your business will not immediately fall apart in the wake of your death. The importance of these plans is going to be highlighted in the coming years. Consider the fact that were more than 30 million small businesses operating in the United States as of 2020, according to the Small Business Administration. These small businesses are in the midst of an unprecedented generational transfer and there is a growing wave of founding business owner exits on the forefront. This is because many baby boomers are quickly approaching retirement age and many are already in the process of transitioning their businesses to a new owner, or group of owners. This is why you need to have a detailed, thorough business succession plan in place. For example, it is generally recommended that a business succession plan incorporate at least an 18-month time horizon.
Here are some other reasons why business succession planning is so important, particularly for small business owners:
When a redemption agreement is put in place, it enables the business entity itself to own your life insurance policy or policies. When there is an active redemption agreement, the proceeds from the life insurance policy would be paid directly to the company, as opposed to the spouse or family member of a small business owner. The business would then use the proceeds from the life insurance policy to purchase the interests of the deceased owner from their personal representative. Once the company purchases the shares, those shares would no longer be outstanding, which means the interests of the remaining owners in the company would simply be adjusted proportionately.
It may be worthwhile to create a redemption agreement since it is fairly simple and offers a centralized form of management to administer the life insurance policy or policies that include collection and distribution of the death benefits.
Another benefit of establishing a redemption agreement is that your life insurance policies would not be exposed to reach by your creditors, or included as part of your estate, since the policies would be owned by the business entity, such as your LLC. In addition, if a member/owner decides to leave the business, the life insurance policies on the remaining owners would not be disrupted the way they would be in a cross-purchase agreement.
While a redemption can be a simple process, there are some potential pitfalls to avoid. For example, if your business entity is a C corporation, the proceeds from a life insurance policy could trigger the alternative minimum tax. It is also important to note that a life insurance policy owned by a company is subject to reach by the creditors of the business entity.
When incorporating life insurance into a business, it may be worthwhile to create a cross-purchase agreement. This agreement would entail the surviving business owners (i.e. not the business itself) purchasing the interest in the business when a business owner passes away. The owners of the business would have ownership over the life insurance policies insuring each other’s lives. Under a cross-purchase agreement, when a business owner passes away, the proceeds from a life insurance policy are paid to the surviving owners who hold one or more policies on the deceased owner. These surviving owners would then purchase the shares from the deceased owner’s personal representative. Any shares the surviving owners purchase from the deceased owner will have a basis equal to what they paid for the shares. Thus, if these shares are subsequently sold at an amount greater than their basis, the surviving owners will be able to take advantage of lower capital gains tax than the other shares they hold.
However, it is important to note that the basis in an S corporation stock or a partnership interest will fluctuate year to year because the basis depends on the operations and distributions of the company.
A benefit of having a cross-purchase agreement in place is to help avoid lender or creditor restrictions imposed on a company’s cash flow, as sales of ownership interests can take place between owners without requiring involvement by the company.
There are some potential pitfalls or drawbacks associated with cross-purchase agreements. For example, if you have multi-member LLC, a cross-purchase agreement does not offer the centralized ownership and management of life insurance policies that is inherent with an aforementioned redemption agreement. Instead, the owners of the business would individually hold the life insurance policies. This could make the administration of these insurance policies more difficult to manage and administer. For example, a life insurance policy held individually by an owner could be part of that owner’s estate in the event they suddenly pass away. In addition, these life insurance policies could be exposed to reach by the creditors of the business owner. Additionally, if an owner decides to depart the business, it may trigger negative tax repercussions since it would necessitate an ownership transfer of any insurance policies the departing owner holds on the lives of the other LLC members/owners.
When multiple owners in a business seek the benefits of a cross-purchase agreement but at the same time want to avoid the risks associated with a cross purchase, they could consider forming a separate manager managed limited liability company (often referred to as an “insurance LLC”).
This insurance LLC would be tasked with holding and administering the life insurance policies taken out on the lives of the LLC members/owners. There are various benefits associated with creating an insurance LLC. For example, since all life insurance policies are held by the insurance LLC and not the individual LLC members/owners, the insurance LLC provides centralized management and creditor protection for the policies. Another benefit is that the insurance LLC can help you mitigate the risk of triggering a large estate tax bill. It also avoids potentially negative tax results if an owner departs the business and policy ownership needs to be modified. While incorporating an insurance LLC into a buy-sell agreement can add further expense and a layer of complexity, the benefits of an insurance LLC often outweigh the costs.
If you opt to form an insurance LLC, the ownership structure should mirror that of your business. In addition, an independent individual should be tasked to serve as the manager. Once the insurance LLC is up and running, the members of the LLC will make annual capital contributions to pay the premiums of the policy. When a business owner passes away, the LLC’s manager will be tasked with distributing the proceeds to those business owners who are required to purchase the deceased owner’s interests under the LLC's buy-sell agreement.
As you can see, there is significant value in having a life insurance policy incorporated into a succession plan for a small business owner, including LLC members/owners. If you are interested in learning more about how life insurance can benefit the longevity of your LLC, contact Alliance America.
Alliance America is an insurance and financial services company. Our financial planners and retirement income certified professionals can assist you in maximizing your retirement resources and help you to achieve your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.
