Business Su c c e s s i o n f o r t h e So l e Ow n e r : On e-way Cr o s s-pu r c h a s e Bu y-sell Ar r a n g e m e n t s Producer Guide For producer use only. Not for distribution to the public.
When considering business succession issues, the sole owner of a business is in a much more uncertain position than an owner who shares an interest in a business with others. As the sole owner, there is often no one else to immediately run the operation should the unexpected take place, which greatly increases the chance for the business to fail or the need for it to be liquidated. With so many day-to-day issues to consider in running a business, thinking about what will happen in the future is viewed by many business owners as a luxury they cannot afford. It is important to remember that without a proper business succession plan in place, all the hard work that they have put into their business can turn into nothing very quickly. 1 Business Succession for the Sole Owner
The Need for Prior Planning Planning ahead is difficult for sole owners because in many cases they do not have anyone else available, such as another owner or key executive, with whom to plan a purchase of the company. They must take on the process of actively locating a third party buyer on their own. Some sole owners assume that they may bequeath the business to surviving family members or a trust, but that may be unrealistic as family members may not want to be in the business, or may not be suitably qualified for the position, as in the case of licensed professionals such as lawyers, engineers, doctors, etc. This is where a buy-sell agreement becomes a useful alternative. Having a buy-sell agreement in place can help to mitigate conflict and speed up the transition by giving business owners a road map for the future. A buy-sell agreement is a legally binding contract that can be used with all types of businesses. Life insurance would be purchased to fund the agreement at the death or retirement of the owner. How the One-Way Cross- Purchase Buy-Sell Agreement Funded with Life Insurance Can Help The one-way cross-purchase buy-sell agreement is especially pertinent to the sole owner. In this type of buy-sell agreement, the owner will have negotiated a sale to a selected buyer prior to death. A prospective buyer may be a key employee, relative, competitor or unrelated third party. Buy-sell agreements are tailored to each client s needs and circumstances, but all would contain certain mandatory provisions such as: n The owner (or his/her estate) will sell to the specific buyer and the buyer will purchase the business interest from the owner. n A price or formula to value the business has been agreed upon. n The assets and liabilities to be transferred are specified. n A means of funding, such as life insurance, is determined so that the buyer is capable of making the purchase. When life insurance is implemented as part of the arrangement, the buyer would purchase, own and pay the premiums on a policy insuring the owner s life. The buyer would also serve as the beneficiary of the policy. Once the death benefit is paid to the buyer, she or he would use the proceeds to purchase the business interest from the owner s estate. Sometimes, when the buyer is a known or related party such as a key employee, an executive bonus plan or split-dollar arrangement can be implemented to help him or her pay the premiums. In order to ensure that the sale will go through at the time of death and that the buyer will not unilaterally back out, some owners set up the oneway buy-sell agreement with an escrow agent as the custodian of the life insurance policy. In such instances, the buyer is subject to restrictions on his or her ability to access the cash values of the policy. Once the owner dies, the death benefit is paid to the escrow agent, who ensures that the agreement is enforced. t r a n s a m e r i c a 2
Producer Guide What are the Advantages? n A buyer is identified ahead of time, preventing a loss of the business or a fire sale. This is especially important for licensed professionals. n Value of the business for estate planning purposes has been set and agreed upon. n The sale proceeds replace the value of the business as well as the lost stream of income for surviving family members. n Life insurance provides a guaranteed means of liquidity to enable the buyer to make the purchase at the needed time. n An escrow arrangement can be used to ensure enforcement of the arrangement. n The decedent s estate gets a step-up in basis, eliminating or reducing the amount of tax due upon the sale. n The buyer has a basis in the business equal to the amount of the purchase price. How would an example of the One-Way, Cross-Purchase, Buy-Sell Agreement work? Owner /Owner s Estate Step 2: Employee Bonus Step 7: Business Interest Step 1: Buy-sell Agreement Step 6: Sale Proceeds Step 8: Income Tax Transmerica Policy Step 4: Premiums Step 5: Death Benefit Step 3: Income Tax on Bonus IRS Key Employee Key to Diagram: 1) Owner has a business. He negotiates a oneway cross-purchase buy-sell agreement with Key Employee. 2) Owner agrees to an employee bonus for Key Employee. Owner can take a compensation deduction for the bonus when made. 3) Key Employee must pay income tax on the bonus. 4) Key Employee uses the after-tax bonus proceeds as premiums for a policy insuring Owner s life. Premiums for the life insurance policy are not tax-deductible. 5) At Owner s death, Key Employee receives policy proceeds. 6) Key Employee uses the income-tax-free proceeds to purchase the business from Owner s estate. Proceeds are transferred to the estate. 7) In return, the business interest is transferred to the Key Employee. Key Employee s basis in the business is the amount he paid to the estate. 8) Owner s estate gets a step-up in basis at death to fair market value, however this does not include income in respect of a decedent (IRD), such as accounts receivables and notes. The estate will pay income tax on the portion of the sale attributable to IRD. 3 Business Succession for the Sole Owner
Lifetime Sale versus Estate Sale The effect of the step-up in basis received by an estate is best understood through the use of an illustration.* Example: Owner creates a business and contributes $50,000 to its start-up. After seven years, the value of the business has increased to $325,000. Assume that Owner s basis remains the same throughout that time. Lifetime Sale If Owner sells the business now, he would be liable for capital gains tax. Estate Sale If Owner dies today and the estate sells the business, the estate would receive a stepped-up basis in the business. $325,000 Sale Proceeds $325,000 Sale Proceeds $50,000 Basis $325,000 Basis Step-up $275,000 Capital Gain $0 Capital Gain $41,250 Capital Gains Tax Due (15%) $0 Capital Gains Tax Due $283,750 Net to Owner $325,000 Net to Owner s Estate *Assuming no assets include income in respect of a decedent. Tax Consequences of a One-Way Cross Purchase Buy-Sell Agreement Generally, the policy death benefit will be federal income tax-free. Although the business owner has gain in the business (selling price less basis adjusted for depreciation) at the date of death or, if used, the alternate valuation date, the estate assets receive a basis stepped-up to fair market value. Thus, if the sale occurs within a short time after death, there would likely be no capital gain recognized on the sale. If the assets included income in respect of a decedent such as notes, accounts receivable, commissions received after death or substantially appreciated inventory then these assets do not receive a stepped-up basis; and ordinary income may also need to be recognized as a part of the sale. This extra tax may be considered when the parties are setting the price of the business in the buy-sell agreement negotiations. If the buyer predeceases the owner, the value of the life insurance policy would be includible in the buyer s estate. Strength and Stability from an Industry Leader Transamerica Life Insurance Company and Transamerica Financial Life Insurance Company (collectively Transamerica ) have the strength and experience to help policy owners as they look ahead to the future. Transamerica was built on a simple, but powerful, promise: to provide quality financial products at competitive prices. Transamerica has been helping families and businesses to secure their financial futures for more than a century, and this tradition of excellence continues today. All business owners want to minimize risk in order to protect themselves and their businesses from economic loss and to increase the likelihood of success. Business succession planning is key to the successful transfer of a company or business interests, especially for sole business owners. For more information about this and other advanced marketing strategies, be sure to visit our Web site at www.tatransact.com, or call our Advanced Marketing consultants at 877-ADV-MRKT (877-238-6758). t r a n s a m e r i c a 4
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 be urged to consult with and rely solely on their own independent advisors regarding their particular situation and the concepts presented here. Transamerica Life Insurance Company, Transamerica Financial Life Insurance Company (collectively Transamerica ), and their representatives do not give tax or legal advice. This material and the concepts presented here are provided for informational purposes only and should not be construed as tax or legal advice. Discussions of the various planning strategies and issues are based on our understanding of the applicable federal income, gift, and estate tax laws in effect at the time of publication. However, tax laws are subject to interpretation and change, and there is no guarantee that the relevant tax authorities will accept Transamerica s 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 July 2009. Transamerica Financial Life Insurance Company is authorized to conduct business in New York. Transamerica Life Insurance Company is authorized to conduct business in all other states. For producer use only. Not for distribution to the public. OLA 1972 0709