Business Owners Beware & Buy-Sell Financing
Business Owners Beware
Are you a business owner? Are you the first one to arrive in the morning, as well as the last one to leave in the evening? Have your employees ever taken home paychecks while you sacrificed your paycheck to the bottomless pit called accounts payable? Have you ever paid your mortgage on a credit card? Over the years, you have worked through physical, mental and financial pain that would have caused other folks to close shop and look for a job elsewhere. As a business owner you have survived untold challenges. If your business is a family business, then you may face some unique challenges to protect and preserve your business…and your family.
It would be an understatement to say that family businesses are the backbone of the American economy. Some 90 percent of all businesses in this country are either family-owned or family-controlled. They come in all shapes, sizes and colors, representing all sectors of our economy. From agriculture, to services, to technology, to manufacturing, family businesses generate an estimated one-half of the U.S. Gross National Product and pay half of all wages earned in this country. Not all family businesses are traditional small businesses either. In fact, about one-third of all businesses included in the Fortune 500 are family businesses. But not all of the family business statistics are rosy.
Why such a dismal success rate? The reasons are as varied and unique as the businesses and business owners themselves. Nevertheless, many of the failed transfers can be traced to three causes: people, taxes and cash.
The family element in every family business can mean the difference between its success or failure during the transfer process. Common triggering events include the retirement, disability or death of the business owner. Tough questions must be asked and answered. Otherwise, a business that took you decades to build can be destroyed overnight. For example, who will run the business after you? Will it be your spouse, one of your children or a non-family member key employee? If not your spouse, will your spouse be financially dependent on the business or financially independent of the business? What arrangements have you made for the inheritance of your business-inactive children? Have you in-law proofed your estate? Thinking ahead to the second-generation transfer of your business, what provisions have you made to encourage thrift and industry among your grandchildren?
Estate Tax Uncertainty
The only certainty about the federal estate tax is its long-term uncertainty with each change in Congress and the White House. Additionally, many states have imposed their own estate taxes, independent of any federal estate taxes. Accordingly, careful monitoring of the economic, political and legal climate is required. Why? Without proper estate liquidity planning, your family may have to sell the family business just to meet an estate tax cash call.
Unless you carefully coordinate your financial plan with your estate plan, there may not be enough cash to fund your ultimate objectives. An appropriately funded estate plan can meet all of your people planning objectives and provide liquidity for estate taxes (and business debts). Life insurance, owned in the proper amount, type and manner, may be effectively used to fund such money matters.
True or false: Most family business owners want their businesses to be liquidated when they retire, become disabled or die. If you answered false, then you are correct. In this article, we will survey the fundamental key to the survival of a family business – a Buy-Sell Agreement (BSA).
A BSA is a lifetime contract providing for the transfer of a business interest upon the occurrence of one or more triggering events as defined in the contract itself. For example, common triggering events include the retirement, disability or death of the business owner. An interest in any form of business entity can be transferred under a BSA, to include a corporation, a partnership or a limited liability company. Also, a BSA is effective whether the business has one owner or multiple owners. As a contract, a BSA is binding on third parties such as the estate representatives and heirs of the business owner. This feature can be invaluable when the business owner wants to ensure a smooth transition of complete control and ownership to the party that will keep the business going. Subject to certain Family Attribution Rules under Internal Revenue Code § 318, a BSA can help establish a value for the business that is binding on the IRS for federal estate tax purposes as provided under Internal Revenue Code § 2703.
A BSA is commonly structured in one of three general formats: an Entity BSA, a Cross-Purchase BSA and a Wait-And-See BSA. Under an Entity BSA, the business entity itself agrees to purchase the interest of a business owner. Conversely, under a Cross-Purchase BSA, the business owners agree to purchase one another’s interests. The Wait-And-See BSA gives the entity a first option to purchase the interest before the remaining business owner(s).
Some common options to fund the purchase obligation under a BSA include the use of personal funds, creating a sinking fund in the business itself, borrowing funds, installment payments and insurance. Of these options, only the insured option can guarantee complete financing of the purchase from the beginning. Accordingly, a proper BSA will include both disability buy-out insurance and life insurance. Since the health of the business owner determines their insurability, any delay in acquiring appropriate coverage could be fatal to the success of the BSA and, with it, the survival of the business itself.
This publication does not constitute legal, accounting or other professional advice. Although it is intended to be accurate, neither the publisher nor any other party assumes liability for loss or damage due to reliance on this material.
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