A good way to pay the premiums is to use a loan against the firm’s assets.
According to the Commissioners 1980 Mortality Table, there’s a one-in-five chance that a 40-year-old business owner will die before reaching 65. If he has a partner, there’s an almost 40 percent chance that one of them will die before he reaches 65. Add partners and the risks climb even higher.
Given these statistics, small-business owners need a business-succession plan, generally referred to as a buy-sell agreement. A properly structured and funded buy-sell agreement is critical to keeping the business in the hands of its owners while maintaining the firm’s value, in the event of one owner’s death.
Buy-sell agreements can be designed for many eventualities—a desire by the owner to sell the business, disability, divorce or death. Any of these events can arise at any time, so it is important to be as prepared for them as possible. A business-succession plan in the form of a buy-sell agreement is therefore critical.
Or consider the case of the business owner who is joined by one of his children who helped build the business and has earned the right to run it one day. But the owner has other children. Finding a way to let each child share in the owner’s legacy is a common estate planning dilemma. A buy-sell agreement can help the owner pass the business to the active child while creating the resources for a financial inheritance for the other children.
However, business owners don’t frequently take this step. Some surveys suggest that less than one-fifth of active business owners have a formal business succession plan. Reasons for this include the distraction they face in running a business and cost.
But cost shouldn’t be a barrier. While there are many alternatives for funding buy-sell agreements, permanent life insurance is popular and meets the needs of many small-business owners.
The premiums can be attractive, and the death benefit is usually free from federal income tax. Nevertheless, some owners may worry that paying the premiums out of pocket will divert cash that might be better used to grow the company, depending on the size of the policy and the age of the insured.
There is another way to pay the premiums—leverage. This is a commercial loan that is taken out against the business assets used to fully fund the insurance policy, giving the owners the agreement they need while preserving resources in ways that keep the business healthy and growing. The life insurance policy’s cash value may grow, offering at least an opportunity to keep up with the growth in the company’s value.
Leveraging assets to fund a buy-sell agreement is not for every client, however. The ideal client needs to have a solid business with a steady stream of income in excess of what the company needs to pay its bills or grow. Other firm assets, such as inventories, holdbacks at auto dealerships or medical receivables that are not already pledged as collateral elsewhere, are frequently considered as well. At the same time, the client must be comfortable with leverage. Most business owners are accustomed to using debt to cover start-up costs or acquire the equipment and workspace that help their businesses grow. Unlike equipment, which depreciates over time, financial products are considered appreciating assets that become more valuable as the years go by, making them an even more attractive option.
Using leverage also takes the right partner. To achieve success, look for an established leader with:
- The banking relationships to provide the financing
- Relationships with legal and tax services to ensure that each transaction offers maximum value to the client
- Relationships with highly rated carriers to provide carefully selected insurance products
It’s also important to work with a partner that has the experience to pull the deal together quickly and can make this investment successful.
Published by Advisor Today. All rights reserved.
Alan M. Harrington, J.D., is president of Global Financial Distributors, a leader in leveraged-based financial strategies for small businesses and entrepreneurs. Email him at firstname.lastname@example.org.