The Importance of Business Succession Planning
Building a successful business takes commitment, dedication, and a lot of hard work. And like anything of value, it must be protected –but not only against current risks such as fire or theft, but also against less tangible hazards such as the loss of an owner or key employee. Let’s face it, at some point in the life cycle of every successful business, one or more of three things will happen: an owner or key employee will die, become disabled, or simply decide to retire. Unfortunately, many business owners don’t take the time to plan for how their business will be run –or liquidated –following such an event. But without this kind of planning –generally known as business succession planning –even successful companies face the threat of failure.
Planning for the sale or transfer of a business or business interest should begin as soon as possible - while the business is successful and while the owners are healthy. In many cases, the foundation of effective succession planning is a buy-sell agreement, which should address:
- How the buy/sell agreement will be funded. Will the money come from the owners themselves, or will the business fund the arrangement?
- What kind of event will trigger the sale –death, disability, retirement? Maybe all three?
- Who will actually buy the business interest –the remaining owners, a key employee or the business itself?
A properly structured –and funded - buy/sell agreement can help answer these questions.
What is a buy/sell agreement?
A buy/sell agreement spells out the process by which a business or business interest are transferred following a “trigger” event –usually the death, disability, or retirement of one of the owners.
Most buy/sell agreements take one of two forms –either they are “entity plans, ”where the business agrees to purchase an owner’s interest in the business, or they are “cross-purchase plans, ”where the business interest is purchased by the other owners. But while there are advantages and disadvantages to each type of plan, in many cases, neither arrangement fully meets the owners’ expectations or objectives. Tax issues, administration headaches, funding inequities, multiple insurance policies –just to name a few –can take much of the luster out of both types of buy/sell agreements. That’s where a Partnership Administration Success Strategy (PASS) can help. Under a PASS Plan, the benefits of both entity and cross-purchase plans can be made available, but without the drawbacks associated with either method.
How can a PASS plan assist in buy/sell planning?
The business owners enter into a cross-purchase buy-sell agreement, and the owners form a general partnership with all owners as general partners. Each partner acquires a life insurance policy on himself and transfers it to the partnership as a capital contribution –the partnership becomes the owner and beneficiary of the policies. Policy premiums can be paid by the business by paying additional salary or bonus to the insured. The insured, in turn, transfers the cash to the partnership as a capital contribution, or the business itself may become a partner in the partnership and pay premiums directly to the partnership as a capital contribution. The general partnership structure allows the partners the flexibility to allocate items of income, profit, gain and loss between themselves in a manner that meets their business objectives. This allows the partners to equalize cost and fairly distribute life insurance proceeds.
Following the death of a partner, the death benefit proceeds from the policy covering that partner are received by the partnership income tax-free, and if appropriate provisions are included in the partnership agreement, the partnership can distribute the policy proceeds to the surviving owners income tax-free. The surviving owners then use the proceeds received to buy the deceased owner's/shareholder's business interests in both the corporation and partnership under the terms of the cross-purchase buy-sell agreement.
Using a general partnership to manage a buy/sell agreement can also be advantageous following the retirement or disability of an owner. In such a case, the partnership can distribute the disabled or retired owner’s life insurance policy to him or her in exchange for his or her interest in the partnership. The departing owner could assume ownership of his or her own policy potentially income tax-free. Over-funding of the life insurance policy(s) –a common strategy - would allow the remaining owners to access cash values in their policies as a resource to help them fulfill their obligation to purchase the departing owner’s interest in the business.
Could a PASS plan be right for you?
The benefits of using a buy/sell agreement to transfer a deceased, disabled, or retiring partner’s share of a business to the remaining owners are many. Unfortunately, the traditional methods don’t always work in the best interests of the business or business owner. Utilizing a general partnership to manage your buy/sell planning, however, could help mitigate the disadvantages presented by entity and cross purchase plans. The general partnership approach:
- Requires only one life insurance policy per owner;
- Avoids the corporate Alternative Minimum Tax;
- Minimizes, through special allocations, inequities among partners in the cost of insurance coverage;
- Provides a full basis increase to the surviving partners after a partner’s death;
- Allows the surviving partners to distribute the insurance proceeds to themselves, generally free of income taxes, in order to accomplish the business buy-out and;
- Permits the transfer of the policy insuring a departing partner to that partner income tax-free.
As a planning vehicle, PASS combines the benefits of both entity and cross purchase plans –as well as additional benefits not present in either –while avoiding the disadvantages inherent in both. For all of these reasons, a Partnership Administration Success Strategy could be just what you, your partners, and your business needs to accomplish your goals and objectives.
This information should not be construed as financial, legal or tax advice applicable to your situation. Please consult with a qualified advisor regarding your individual circumstances. Content prepared by Penn Mutual.
©2014 The Penn Mutual Life Insurance Company, Philadelphia, PA 19172