SUCCESSION PLANNING | BUSINESS

These agreements are structured so that each partner buys and owns a policy on each of the other partners in the business. Each partner functions as both owner and beneficiary on the same policy, with each other partner being the insured; therefore, when one partner dies, the face value of each policy on the deceased partner is paid out to the remaining partners, who will then use the policy proceeds to buy the deceased partner’s share of the business at a previously agreed-upon price.
Example: How a Cross-Purchase Agreement Works.

Assuming there are three partners with each owning equal shares of a business. If the business is worth a total of $3 million, each partner’s share will be valued at $1 million. The partners want to ensure that the business is passed on smoothly should anyone of them dies. They can enter into a cross-purchase agreement requiring each partner to take out a $500,000 policy on each of the other two partners. This way, when one of the partners dies, the other two partners will each be paid $500,000, which they must use to buy out the deceased partner’s share of the business.

The limitation here is that, for a business with more partners (five or more), it becomes impractical for each partner to maintain separate policies on each of the partners’ lives. There may also be substantial inequity between partners in terms of underwriting and the cost of each policy due to age and health issues. In this instance, an entity-purchase agreement may be considered as an alternative.

The entity-purchase arrangement is much less complicated. In this type of agreement, the business itself purchases a single policy on each partner and becomes both the policy owner and beneficiary. Upon the death of any partner or owner, the business will use the policy proceeds to purchase the deceased person’s share of the business accordingly. The cost of each policy is generally deductible for the business, and the business also “eats” all costs and underwrites the equity between partners.

Creating and implementing a sound succession plan will provide several benefits to owners and partners:

• It ensures an agreeable price for a partner’s share of the business and eliminates the need for valuation upon death because the insured agreed to the price beforehand.
• The policy benefits will be immediately available to pay for the deceased’s share of the business, with no liquidity or time constraints. This effectively prevents the possibility of an external takeover due to cash flow problems or the need to sell business or other assets to cover the cost of the deceased’s interest.
• A succession plan can greatly aid in allowing for timely settlement of the deceased’s estate.

The Bottom Line.

• Proper business succession planning requires sound preparation. Business owners seeking a smooth and equitable transition of their interests should seek a competent, experienced advisor to assist them in this matter.