The insurance needs of small business owners too often are overlooked by advisors. In fact, LIMRA, the insurance and financial services trade group, does not even track sales information on small business life insurance policies, according to Kate Theroux, spokesperson.
Yet, business owners purchase more life insurance than other individuals, according to at least one study by Douglas Holtz-Eakin and others with the Center for Policy Research at Syracuse University. More than one-third of individual policies purchased are motivated, in part, by business concerns, the study said.
Holtz-Eakin stresses that business owners often don’t consider the impact of estate-tax planning when they buy coverage—despite the fact that it may be difficult to liquidate a business to pay estate taxes. In 2012, amounts over $5 million are subject to estate taxes. But this could change in the future.
Holtz-Eakin’s research suggests that advisors should work with estate planning attorneys. The right type of insurance trust to cover the tax or for wealth replacement might help.
A buy-sell agreement, which establishes a predetermined formula for selling the business interests of the owner, partner or shareholder, is a common option. This type of agreement shoulddetermine ownership of the business and the financial consequences to owners and their families when one owner retires, becomes disabled, goes into personal bankruptcy, divorces, wants to leave the company or dies.
A report by Nationwide Insurance, Columbus, Ohio, suggests that life insurance can help in this quest.
The death of a small business owner may lead to internal turmoil, customer erosion and disruption in revenue flow, Nationwide says. A buy-sell agreement-funded life insurance policy can help prevent these problems from arising and potentially damaging the business.
Most business owners, the Nationwide report says, typically implement one of the following plans:
Cross-purchase plan—In this plan, typically limited to businesses with just two or three owners, each owner purchases life insurance on each of the other owners. When one owner dies, the surviving owners use the death benefit to purchase the deceased owner’s share of the business.
Entity purchase or stock redemption plan—Each owner enters into an agreement with the business for the sale of their respective interests back to the business. The business purchases separate life insurance contracts on the lives of each owner, pays the premiums and is both the policy’s owner and beneficiary. When an owner-employee dies, his or her share passes to the heirs of the estate. The business may use proceeds from the policy to purchase the interest from the estate.
However, before you tackle a buy-sell deal, Barbara Weltman, a Millwood, N.Y.-based tax attorney, says you had better make sure the agreement is legally correct.
“A buy-sell agreement is like a Last Will and Testament for a business because it spells out what happens when a co-owner dies,” she says “It is a binding contract that dictates who can acquire an interest by sale or transfer, how much that interest is worth, and how the interest will be paid. Unfortunately, many owners fail to work out the details with their partners/shareholders before it’s too late, leaving their families in turmoil and creating tax and financial problems that could have been avoided.”
It’s best to work out the "what ifs" before they happen and at a time when owners are on good terms with each other, she advises. A client should consider writing one when starting a business. Also, don’t use sample template agreements that can be purchased online, she warns. It’s better to work with an attorney.
Key legal ingredients to a buy/sell life insurance contract, she says, include:
· How much a departing owner’s interest in the company is worth. This can be problematic unless the buy-sell agreement creates a mechanism for making a pricing determination, such as an appraisal by an independent appraiser, a fixed value based on the company’s revenue, book value or other benchmark. There may be a formula based on a financial benchmark or based on a certain financial amount, such as 5 percent of the earnings.
· A non-compete clause that limits the ability of a departing owner to set up a competing business. This agreement should also prohibit an owner from selling or gifting his interest unless it is first offered to the other owners. This avoids bringing unwanted people into the business. It also helps fix the value of an owner’s interest for estate purposes.
· Consideration of where the money is coming from to pay for the buyout—life insurance or company revenue.
Weltman stresses that if owners are relatives, the value in a buy-sell agreement will be respected for federal estate tax purposes only if it meets three conditions:
· The agreement must be a binding contract among the parties.
· The agreement cannot be used as a device to transfer property to family members at less than full and adequate consideration in order to escape estate-tax costs.
· The terms must be ones that would be used if the owners were unrelated.
“If the agreement fails to meet all three conditions, the IRS can disregard the agreement for estate-tax purposes and set a higher value,” she says. “This can result in added estate tax costs, although with today's estate tax uncertainty, no one knows how much.”