Vol 12 No 8		August 2010

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Business Continuation Planning:
Part I

The continuation of closely-held businesses should be planned for because there is no ready market for the transference of ownership and many do not have non-owner executives and managers.

A central part of business continuation planning involves the appropriate purchase of life insurance and disability buy-out insurance. This Perspectives and the September Perspectives will address important issues and subtleties that might be considered when assisting with business continuation planning, commonly referred to as buy-sell planning.

Business continuation planning refers to the disposition of a closely-held business interest in the event of retirement, permanent disability or death of business owners. Business owners should have a strategic legally binding plan for the continuation or liquidation of their business in the event of an unexpected permanent disability or death of a partner, otherwise its value could be greatly dissipated and the potential for conflict with the permanently disabled or deceased partner's family greatly increases. Planning for retirement usually should not be part of a legally binding document because it is voluntary and negotiations with other partners about retirement should take place at the time it is being considered.

Sam and Pranab - The Early Years

Sam and Pranab are equal owners of an engineering consulting firm, which is a C corporation. They employ five others, including two other engineers. They need to negotiate a buy-sell agreement. They will need to work with an attorney, insurance specialist and accountant. The buy-sell agreement is important because it establishes the ground rules of the business transfer and establishes a price for this transfer. Further, a properly drafted buy-sell agreement will bind their families to the provisions they formalize in the agreement making it much less likely that trouble will arise after a permanent disability or death.

Sam and Pranab decide their business is worth $3,000,000, about half of which is goodwill. They understand that the adjusted book value is not a good reflection of how valuable the business is to them and are therefore encouraged to revise the value each year on an exhibit to their buy-sell agreement rather than to rely on a formula provided in the agreement.

Once the value has been determined Sam and Pranab need to decide whether the agreement should be an entity or cross purchase. Whether an entity or cross purchase is selected life insurance should be purchased to fund the purchase obligation in the event of the death of Sam or Pranab. For an entity purchase the life insurance is owned by and payable to the corporation. For a cross purchase a policy insuring Sam's life is owned by and payable to Pranab and a policy insuring Pranab's life is owned by and payable to Sam. Conventional universal life (not no lapse) with a specified death benefit plus the cash value is ideal for either an entity or cross purchase because of its flexibility since its premium can be treated as term insurance in years the company has cash flow problems and in normal years higher premium funding will cause the death benefits to increase which might coincide with the company's value increasing. Tracking the company's value is important to keep the life insurance funding in line with increasing values. If significant increases in business value were to occur, additional life insurance might have to be purchased to keep up. Typically, any business value in excess of life insurance proceeds will be paid, usually over five to 10 years, to the deceased shareholder's family at an agreed upon interest rate so keeping the life insurance funding up to date is important so the surviving shareholder's out-of-pocket obligations are manageable.

If the buy-sell agreement provides that a permanently disabled shareholder's stock is to be purchased disability buy-out (DBO) insurance should be purchased to fund this obligation. As is the case with life insurance the DBO policies can be owned by the corporation under an entity purchase plan or cross owned by Sam and Pranab under a cross purchase plan. A DBO policy will offer different waiting periods (usually one or two years) and different pay out alternatives (usually lump-sum to five years). As is the case with life insurance, a DBO policy owned by and payable, for example, to Sam will increase his cost basis when Sam uses the DBO proceeds to buy Pranab stock following Pranab's disability. A common mistake I see is business owners confusing disability income (DI) insurance with DBO. DI insures the disabled shareholder's loss of income; DBO provides the funding to redeem his stock. Finally, before including permanent disability as a buy-out trigger funded with DBO thought has to be given to whether the shareholders really want this to occur. It is possible because of the business structure (S corporation for example) and level of profits that shareholders would want to continue owning stock during a permanent disability and receive a share of the profits.

Often business owners don't purchase DBO because of its expense. In that event, the buy-sell agreement might be silent as to how a permanent disability should be handled so the non-disabled owner isn't obligated to an expensive stock redemption that can't be afforded. In that case the partners will just have to make the best of it. Many business owners think that disability income insurance they have is covering a buy-out. It isn't.

Dave's Construction Company (DCC)

Dave is 40 and has been in the construction business for 10 years. He owns 100% of DCC stock that has an adjusted book value of $3.0 million. Dave has reinvested most profits and has accumulated few investment assets outside DCC. None of his three children are old enough for him to know if they will eventually come into the business with him. DCC has one key employee, Hal, who is 35. Dave is concerned about what would happen to his family and DCC if he had the bad judgment to die. A local insurance agent is trying to convince him to give Hal 1% of the stock and set up an entity buy-sell agreement with DCC to purchase his stock, leaving Hal with all of the outstanding stock. DCC would own a $3.0 million life insurance policy on Dave's life to fund this obligation. Dave wants a second opinion on this recommendation.

The net result of the recommended buy-sell plan is to give a $3.0 million business to Hal, via DCCs (really Dave) purchase of life insurance, and to have Dave's family exchange $3.0 million in DCC stock for cash without otherwise adding any value to the estate. This is a great deal for Hal, but a horrible deal for Dave's family. Instead, Dave should consider purchasing a $3.0 million life insurance policy to be owned by and payable in an irrevocable trust with his wife and children as the beneficiaries of this trust. Then privately instruct his attorney, accountant and wife, in writing, to work closely with Hal (since he knows the market and other construction firms) in the event of Dave's untimely death to begin immediate negotiations for the sale or liquidation of DCC with Hal receiving compensation for this service. In so doing Hal may be able to secure key employment with DCC's successor owner, including the possibility of a minority ownership interest. What this does for Dave's family is to secure the value of DCC in the form of life insurance in the irrevocable trust, plus the additional value that will probably come from the immediate sale or liquidation of DCC which might be close to the $3.0 million adjusted book value. By instructing his advisors and wife to move quickly to sell or liquidate DCC, with Hal's full assistance, Dave has substantially increased the prospects of getting the maximum value for DCC with the greatest likelihood that DCC employees will still have their jobs because there is a definite and immediate plan in place to sell or liquidate DCC. For the same insurance costs Dave has potentially increased his estate by some $3.0 million for his family's benefit rather than basically giving his company to Hal.

Since Dave has been reinvesting profits back into the business he will probably use term insurance for the time being in the irrevocable trust.

While this planning is a good match for Dave's current objectives it needs to be reviewed every several years to properly manage the performance of the life insurance policy, confirm Hal's present key role and to check whether one or more of Dave's children might have entered the business.

In September I will continue with several other business continuation case studies as a way of looking at other potential complexities encountered in business continuation planning.