Business Succession Planning for the Sole Owner

One-Way Cross-Purchase Buy-Sell Agreements

OLA 1957 0509

This material was not intended or written to be used, and cannot be used, to avoid penalties imposed under the Internal Revenue Code. This material was written to support the promotion or marketing of the products, services, and/or concepts addressed in this material. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely solely on their own independent advisors regarding their particular situation and the concepts presented here.

The Sole Owner – Different from Multi-Owner Companies

Problematic – incapacity or premature death

No co-owners to run company in interim

No obvious successor

May cause termination of entity

Loss of stream of income for family

Fire Sale – loss of significant percentage or ALL value

What happens at owner’s death?

Termination of business

Sole Proprietorships

Partnerships

Professional Corporations

Managed by Executor

S Corporations

C Corporations

Limited Liability Companies

Bequeathing Business via Will

Common approach, but why is this a problem?

Family members:

Children often not involved in business

Executor may not want to run business

Successor not fully trained/mentored

May not be qualified – lack professional certification

Owner associated with Entity

Loss of owner results in loss of goodwill

Personal relationships with clients

Personalized service only owner provided

An alternative strategy.

The owner will have negotiated a sale to a selected buyer prior to death

A sale is agreed to at a set price at a triggering event (death, retirement, disability, specified date, etc.)

Entity redemption not an option—entity cannot exist without an owner/manager of operations.

One-Way Cross-Purchase Buy-Sell Agreement

One-Way Cross-Purchase Buy-Sell Agreement

Potential Buyer

Key Employee

Relative Competitor

Friend/Colleague

UnrelatedThirdParty

Pool ofPotential Buyers:

Buy-Sell Agreement contracts vary in terms, but allcontain following mandatory provisions:

One-Way Cross-Purchase Buy-Sell Agreement

The owner (or his/her estate) will sell to the specific buyer, and the buyer will purchase the business interest from the owner

An agreed upon price or formula to value the business

Specified list of assets and liabilities to be transferred

A means of funding, such as life insurance, is chosen so buyer is capable of making purchase

Funding the Agreement – Term vs. Perm

Parties to agreement often want to fund with term insurance,due to lower premiums, but permanent insurance may be moreappropriate because:

Triggering event for buyout often occurs for reason other thandeath (e.g. retirement, disability, specified date)

Buyer can use cash accumulation in a permanent policy to fund a lifetime buyout

Permanent policy with cash value build-up works better for a long held, well-established business

Length of agreement may extend beyond time that term isavailable (gets too costly after a certain age)

At time participants want to switch to permanent, insured may be in poor health or uninsurable.

Candidate to replace owner – Key Executive in Business

As salaried employee, may lack funds for buyout

Owner can implement Executive Bonus arrangement to fund policy

Premiums are paid through taxable bonus to executive

Employer receives a §162m deduction (as compensation)

Executive purchases life insurance policy

Executive is owner and beneficiary of policy

Employer may add “double bonus” to cover estimated income tax liability to Executive on both bonuses

Premiums are not tax deductible for Executive

With a Restricted Bonus, executive has limited access to cash value of policy based on certain events (e.g. disability of owner)

Key Executive as Buyer – Executive Bonus

Life Insurance Purchase: Executive uses bonus payment (minus income taxes) to purchase life insurance policy.

Accessing Benefits: Executive has access to policy’s cash value at predetermined time or specified event.

Executive receives death benefit, used to fund buyout of owner’s business interest.

Bonus Payment: Employer makes taxable bonus payment to executive and receives corresponding income tax deduction.1 Executive reports bonus as additional income.

Life InsuranceEmployer

Executive

Executive Bonus: Here’s How it Works

1 Provided amount of bonus is reasonable and employer retains no ownership rights or beneficial interest in the policy.

Setting up the buy-sell agreement with an Escrow as intermediarycan serve many purposes:

Ensures enforcement of the arrangement

Prevents likelihood of buyer unilaterally backing out of agreement after owner’s death, and keeping policy proceeds.

Custodian of life insurance policy

Ensures payment of premiums

Prevents access by creditors

Preserves integrity of policy (prevents policy withdrawals, which could cause lapse)

Using an Escrowed Buy-Sell Arrangement

One-Way Cross-Purchase Buy-Sell:Here’s How it Works

Example:

Felix owns cleaning service, sole proprietorship

At his death, company would liquidate

Goals: To ensure his wife and children are taken care of after his death with a lump sum or stream of income

Felix’s Cleaning ServiceFelix, Sole Proprietor

How it Works Example – Felix’s Cleaning Service

Example:

Oscar was once one of the worst employees

After many years, Oscar has shaped up and is the best, and manages all the other cleaners

Goals: Felix decides to choose Oscar to take over the business when he leaves. Oscar jumps at the chance.

Oscar, Head CleanerKey Employee

How it Works Diagram – Felix’s Cleaning Service

Buyer(Oscar - Key Employee)

Sole Proprietorship(Cleaning Service)

Sole Proprietor(Felix/Felix’s Estate)

IRSTransamericaPolicy

(on Felix)

I. During Felix’s Life:

1) Buy-Sell Agreement

2) Employee Bonus/Employer Deduction

4) Premiums3) Income Tax

on Bonus

How it Works Diagram – Felix’s Cleaning Service

IRS

II. At Felix’s Death:

7) Business Interest 6) Sale Proceeds

5) Death Benefit

8) Income

Tax on IRD

Buyer(Oscar - Key Employee)

TransamericaPolicy

Sole Proprietorship(Cleaning Service)

Sole Proprietor(Felix/Felix’s Estate)

Tax Consequences

If employee bonus used: Deduction allowed for business

Income must be recognized by Key Employee/Buyer

Generally, policy death benefit federal income tax-free Owner’s estate receives step-up in basis at death, so no capital

gain in business likely to be realized Income in Respect of a Decedent (ex. notes, accounts

receivable, commissions received after death, substantially appreciated inventory):

No step-up in basis at death

Subject to ordinary income tax

If buyer predeceases owner, value of life insurance policy is included in buyer’s estate

Effect of Estate Basis Step-Up

Lifetime Sale versus Estate SaleThe effect of the step up in basis received by an estate

is best understood through the use of an illustration.

Example: Owner creates a business and contributes $50,000 to its start up. After 7 years, the value of the business has increased to $325,000. Assume that Owner’s basis remains the same throughout that time.

Lifetime Sale Estate SaleIf Owner sells the business now, he would be liable for capital gains tax.

If Owner dies today and the estate sells the business, the estate would receive a

step up basis in the business.

$325,000 Sale Proceeds $325,000 Sale Proceeds

$50,000 Basis $325,000 Basis Step-up

$275,000 Capital Gain $0 Capital Gain

$41,250 Capital Gains Tax Due (15%) $0 Capital Gains Tax Due

$283,750 Net to Owner $325,000 Net to Owner’s Estate

Advantages

Sole Owner

Key Executive/Buyer

Known buyer at death or retirement

Plan for management of business at death or retirement

Sale proceeds a source of income for family

Pegged value of business

Offer to own business Funding (life insurance) to

pay purchase price Basis in business interest

equal to purchase price

Transamerica Life Insurance Company, Transamerica Financial Life Insurance Company (collectively “Transamerica”), and their representatives do not give tax or legal advice. This material is provided for informational purposes only and should not be construed as tax or legal advice. You should rely solely upon your own independent advisors regarding your particular situation and the concepts presented here.

Discussions of the various planning strategies and issues are based on our understanding of the applicable federal tax laws in effect at the time of presentation. However, tax laws are subject to interpretation and change, and there is no guarantee that the relevant tax authorities will accept Transamerica’s interpretations. Additionally, this material does not consider the impact of applicable state laws upon clients and prospects.

Although care is taken in preparing this material and presenting it accurately, Transamerica disclaims any express or implied warranty as to the accuracy of any material contained herein and any liability with respect to it. This information is current as of April 2009.

Transamerica Financial Life Insurance Company is authorized to conduct business in the state of New York. Transamerica Life Insurance Company is authorized to conduct business in all other states.

OLA 1957 0509

Business Succession Planning for the Sole Owner

One-Way Cross-Purchase Buy-Sell Agreements

OLA 1957 0509