Making a Graceful Exit: The Value of Life and Disability Insurance to your Exit Strategy Pre- and Post-Sale

More About | Succession
2019 Succession Planning Series Installment #3

Sometimes business owners jest that they would sell “this Friday,” which may not be far from the truth! However, business exit strategists advocate for developing your exit strategy when developing your business plan. In practice, they find that business owners want to retire and sell their business in five, ten or 20 years. Life and disability insurance policies are often valuable assets that can complement your financial, estate and business plans prior to and after the sale of a business.

Proper planning and insurance diagnostics can determine if your insurance portfolio can appropriately complement your exit plan with the right funding in the right places. Critical elements in exit planning while considering the owner’s goals and objectives may include:

  • Financial security of the owners, spouse and others
  • Coordination for retirement planning
  • Determining successor management
  • Transfer tax minimization
  • Estate planning
Life and Disability Considerations

Life insurance is effective in succession planning while also giving you a safety net in the event of a premature death or disability during the life of the business. Implementing legal and insurance planning should take place in the early stages of business development when debt and risk are high, resources may be limited, and there is an adequate horizon of time to allow accumulation of cash value. Specific to family businesses, insurance can play a critical role with active and inactive family members after the death of a founding shareholder. Without life insurance, most family businesses cannot buy out non-active family members, and bitter disputes can arise over declaring dividends, investing back into the company, salary decisions and management of the family business. Life insurance provides an instant source of liquidity that, if structured properly, is tax-free.

Disability for business owners is often overlooked, yet the possibility of a disability is higher than death. Addressing a triggering disability and how it will be funded is important, since one in four twenty-year-olds will become disabled before they retire.

Funding the Buy-Sell Agreement

For intra-family succession and closely-held businesses, typical planning may include buy-sell agreements. This legal document creates a market for the owner’s interest in the business including death, disability, divorce or retirement. Life insurance policies can be purchased on the lives of each partner to provide adequate funding and liquidity to buy out family members or surviving shareholders. This solution sounds simple, but it is hardly foolproof. The advisor team should be familiar with the tax implications of a cross-purchase agreement and a stock redemption buysell agreement. For sole proprietors, a one-way buy-sell agreement offers marketability to transfer ownership to a key employee or family member after an expected death.

A valuation formula should also be written into the buy-sell agreement. Accurate valuations are critical for tax and nontax reasons and are instrumental in avoiding shareholder disputes and conflict, especially after a triggering event like a death or disability when emotions and stress are at their height. Contractual language addressing restrictions, valuation disputes such as mediation and/or arbitration should also be in the legal documents.

The “Key Person”

Many businesses rely on key people that may be nonfamily and family employees. Special skill sets and client relationships make key people irreplaceable and critical to ongoing success of the business. Life insurance can indemnify the company against the loss of that individual and allow the company the necessary time to find replacement personnel. Cash value life insurance is also an effective tool to create “golden handcuffs” in order to retain key personnel through a period of transition until retirement or until the end date of a non-compete agreement. Life insurance has the tax advantage of tax-deferred, making it ideal to informally fund Non-Qualified Deferred Compensation plans. An employee’s violation of the terms of the agreement will cause forfeiture of the benefits promised within the agreement.

Financial and Estate Planning – The Value of Insurance Post-Sale by Example

As described above life and disability insurance provide a financial safety net for business owners while building their business; however, life and disability insurance may also continue to be a valuable post-sale asset. For example, younger business owners may build and sell multiple businesses prior to full-time retirement, in which case the insurance financial safety net described above continues to make sense. Nevertheless, when the final business sale does occur, permanent life insurance often continues to be a valuable asset as outlined in the following examples:

  • To efficiently pay estate taxes – Whether an estate is illiquid or liquid, it costs 100 cents on the dollar to pay estate taxes with cash, and more than 100 cents on the dollar to pay estate taxes by loans (commercial or via Section 6166) or by selling appreciating investment assets; however, the premium cost (including time value of money) to provide one dollar of income and estate taxfree death benefit to pay estate taxes may be as low as 60 to 70 cents on the dollar at the insured(s) average life expectancy.
  • To equalize an estate – Let’s say a business owner has two daughters; one is a key person in the business, and one a homemaker. The daughter who is a key person has 30 percent sweat equity interest in the business worth $3 million and will purchase the remaining 70 percent of the business from her parents for $7 million. Prior to their deaths, in retirement the parents spend $3 million from the sale of their business, leaving each daughter a $2 million inheritance. Now the key person daughter wholly owns a $10 million business, for which she paid (outof-pocket) approximately $5 million. The parents could to some degree equalize the homemaker daughter’s inheritance by making her the beneficiary of a life insurance policy that pays at the death of the surviving parent. The insurance proceeds could be paid directly to the homemaker daughter or paid to an irrevocable trust for her benefit if asset management or uncertainty concerning the daughter’s marriage is a consideration.
  • To fund non-qualified deferred salary continuation – In addition to a lump sum sell price, the current owner of a business also negotiates an annual $100,000 nonqualified salary continuation payment for 10 years (period certain). Based on her financial plan, she believes this income will pay her core expenses, thus freeing her to invest the lump sum payment for the business somewhat more aggressively. Although not contractually linked to this business liability, the business owns and may utilize the cash value of an in-force key person policy on the departing owner’s life to fund a portion of the departing owner’s salary continuation. If the business withdraws cash from the policy to cost basis and then takes policy loans thereafter, the money from the policy is received by the business free of income tax. The salary continuation payments are deductible to the business and are taxable to the departing business owner. The business also may be able to recoup some of the cost of these payments from the net death benefit of the key person policy when the departing business owner dies. The death benefit will be income tax-free to the business, and the business only needs to prove Insurable interest in the life insurance policy at the inception of the contact. This business also has three key employees on the management team whose value to the business (assuming they continued to work there after the sale) was a significant part of the sale price. Because many competitors would like to hire this management group, these three top hat employees have a similar Non-Qualified Deferred Salary Continuation Plan, and they (like the departing owner) are insured by key person permanent cash value life insurance policies that may informally help fund the company’s deferred compensation liability 1.
Overview of the Need, Composition, and Value of an Insurance Diagnostic – Pre- and Post- Business Sale

Insurance policies are often acquired piecemeal over time. Sometimes the policy owners do not adequately understand the contract at point of purchase, or in future years may forget important non-guaranteed aspects of the policy that require active oversight. In too many cases the financial, business and estate plans that substantiate the purchase of the insurance contract are not current, and sometime insurance policies are poorly structured from a tax perspective.

For example, let’s assume insurance diagnostics have revealed some of the following:

  • $1 million death benefits subject to income taxation due to Transfer for Value and 101(j)(4) issues;
  • Lapsed policies that trigger phantom income taxed at ordinary income tax rates due to a lack of understanding of how policy loans affect cost basis;
  • The poor plan design of a buy-sell agreement resulting in the inefficient use of step up in cost basis, resulting in higher capital gain taxes due at the subsequent sell of the business;
  • And a $50,000 annual increase in premium on a $10 million permanent life insurance policy due to a lack of understanding of the premium risk associated with a blended policy subjected to a sustained decline in policy performance.

In conclusion, a proactive periodic insurance diagnostic is the heart of a well-managed insurance portfolio. In a one to twopage summary statement (supported by in-depth reports), an insurance diagnostic can:

  • Organize all contacts into an easy to analyze format;
  • Perform cost-benefit analysis of policy performance;
  • Reveal and stress test the non-guaranteed aspects of contracts;
  • Examine how contracts are structured from a tax perspective;
  • And substantiate if the policies currently compliment the policy owner’s and beneficiary’s financial, business and estate plans.

An insurance diagnostic thus enables you to answer these five questions: (1) Do I have too little or too much insurance? (2) Is my coverage cost effective? (3) Do I understand my contracts, especially the non-guaranteed aspects? (4) Do I understand how my contracts may perform under stress? (5) Are my contracts structured correctly from a tax perspective? Therefore, to be certain of the sustained value of any life and/or disability insurance as part of your exit strategy and business plan, a proactive and periodic insurance diagnostic is highly recommended for any insurance portfolios.

Please contact the authors below for any questions or further information or reach out to us at info@dhg.com.

Notes

  1. It is important to note that Non-Qualified Deferred Salary Continuation Plans are governed by Section 409(A) of the Internal Revenue Code, and significant financial penalties apply for non-compliance. In the scenario described above, it is critical that the business annually models the cash value withdrawals and policy loans so that the insurance contract does not lapse, but instead matures at the death of the insured assuming a conservative (long) life expectancy. A policy lapse will trigger phantom income and ordinary taxable gain to the extent withdrawals and loans exceed the policy’s cost basis, which is reduced by cash value withdrawals and policy loans.

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