Too often entrepreneurs spend years building a business and come to an agreement with a partner or family member over succession, but fail to make plans to finance the succession. That is where life insurance plays a role. By insuring the head of a small business corporation or each senior partner, a small business can weather the death of a partner and ensure succession follows the course intended by the entrepreneur.
Small business owners usually need Permanent or Universal Life Insurance, rather than term insurance. Permanent insurance is necessary because it lasts for your lifetime - a term policy that ends at 75 is no good if a 75-year-old still has all his capital tied up in the business. Succession is a big issue for small companies and you need advice from someone who understands the role of life insurance. Your best choice of advisor is a Chartered Life Underwriter (CLU) or Certified Financial Planner (CFP).
The planning process must include preparation for paying of estate taxes on the business. When a small business owner dies, an assessment is made on the value of the business. If it qualifies as a closely held corporation, there is no capital gains tax on the first $750,000 of value in the business. The tax-free amount may be offset by any capital business losses the owner declared in his or her lifetime.
Insurance can be used to cover capital gains tax on the value of the business over and above $750,000. Depending on the structure of your succession agreement, you might use life insurance to allow a partner to buy out your share, an heir to take over or to provide an inheritance to a child who is not involved in the business.
Suppose a sole proprietor has built a business valued at more than $1 million. He wants his son to take over, but is worried about estate taxes. When he dies, his estate will owe taxes on the capital gain in the business. There may be very little to go to his wife, because of the huge tax bill and his son may have to take out a loan he cannot afford.
The solution is a life policy on the sole proprietor sufficient to pay the taxes. The company itself takes out the policy and pays the premiums. When he dies, the death benefit goes to a capital dividend account, minus the amount spent in premiums. That benefit can be used to pay the estate taxes and his son can take over the business. The son benefits from the new adjusted value of the business and can keep on building.
A similar arrangement can be made between partners. Many partners sign an agreement that they will buy one another out, but if one partner dies unexpectedly, there is no guarantee the other partner will be able to get a bank loan to cover the cost of half the business they have built together. The deceased's family finds their wealth is tied up in the business and they face both estate taxes and a partner who cannot live up to the agreement.
If the partners buy cross-owned insurance - making each other or the company the beneficiary when they die, the money will be available to buy out the other partner. The widow or widower must sell to the partner and the money is there to cover the cost.
Partnership or Shareholder Agreements can also be funded with Disability or Critical Illness Insurance in the event of a permanent disability that results in one partner or shareholder having to buy out the other entity.
Small companies are often dependent on the expertise of a few top people. If a major sales rep or an executive dies, becomes disabled or suffers a critical illness, it can hurt business prospects. Some entrepreneurs take out key person insurance to protect against the loss or disability of their best employees. If that key person dies or becomes disabled before retirement, the business will use the money to go out and recruit someone of equal experience, at a premium salary covered by the disability, critical illness or death benefit.
What if the entrepreneur wants to retire, and turn his business over to a promising heir? How can he turn her equity in the company into capital to fund her own retirement? Many small companies opt to continue paying a salary to the retired founder of the business. Or an heir can slowly buy his shares, supplying a regular income. However, if he has a universal life insurance plan, now may be a good time to take the value out of that contract to fund her retirement or leverage against the plan for potentially tax free income.
The smallest businesses may not be worried about paying estate taxes so much as leaving an equal legacy for each of their children when they cannot all be involved in the business. Bob and Mary Entrepreneur have built a Mom and Pop business valued at $1 million. They want to leave it in the capable hands of their daughter, Laura, who has been a long-time participant in the business. But there is little outside the business to leave to their son, Michael, who chose a separate career.
Upon their deaths, both Bob and Mary can claim the $750,000 capital gains exemption. Their wills can specify that Laura inherit the business. But both or either can take out insurance on themselves to ensure there is an inheritance for Michael. The policies would list Michael as beneficiary, and the money goes to him tax-free. Our advisors can recommend the proper amount of the insurance benefit - it is not necessary to equal the full $1 million value of the business because Laura is inheriting something that requires a lifetime of hard work.