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Business Succession Planning for the Sole Owner

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1 Business Succession Planning for the Sole Owner
One-Way Cross-Purchase Buy-Sell Agreements Business Succession Planning for the Sole Owner OLA

2 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. 2

3 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 When considering business succession issues, the sole owner of a business is in a much more uncertain position than an owner who shares an interest in a business with others. Since he or she is the only owner, should something happen often there is no one else to immediately run the operation and the business may fail or must be liquidated. Planning ahead is also difficult for sole owners because in many cases they do not have anyone else available, such as another owner or key executive, with whom to plan a purchase of the company, and so must actively locate a third party buyer. Without prior planning, the executor or trustee of the owner’s estate/trust may run the business for a short period of time, but ultimately they will likely decide to sell. Selling under pressure to obtain proceeds, a fire sale, usually results in a lower return than if the sale was carefully planned. Certain types of entities require the business to be sold or liquidated. In the case of a sale or liquidation, both result in a loss of stream of income for the decedent owner’s family. This can be devastating if the owner was the primary breadwinner or died prematurely with a young family.

4 What happens at owner’s death?
Termination of business Sole Proprietorships Partnerships Professional Corporations Managed by Executor S Corporations C Corporations Limited Liability Companies Certain types of entities require a liquidation of the company when the sole owner dies, unless the owner has made provisions before his death for continuing or transferring the business. Those include Sole Proprietorships, Partnerships and Professional Corporations. Other types of entities may not terminate when the owner dies, but require a plan to continue operations. Such entities include S and C corporations as well as Limited Liability Companies.

5 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 Some sole owners assume they may bequeath the business to a surviving family member or a trust, but that may be unrealistic as such individuals may not want to be active in the business or no one may be suitably qualified, as in the case of licensed professionals such as lawyers, engineers, doctors, etc. Many sole owners’ personal service is so tied up with the identity of a business that their departure through illness or death may result in a substantial loss in customer relationships or accounts, if it is perceived that the value of the business came from one person rather than operations as a whole.

6 One-Way Cross-Purchase Buy-Sell Agreement
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. An alternative option for the owner to consider is the one-way cross purchase buy-sell agreement. In a one-way cross purchase buy-sell, the owner will have negotiated a sale to a selected buyer prior to death. Using financial and legal advisors, the owner and the prospective buyer execute a buy sell agreement. Within the agreement contract, the sale or purchase price is either agreed upon or a formula to determine the price is agreed upon. One or more triggering events that cause the sale are listed, including such things as death, disability or incapacity or retirement of the owner.For a sole owner, only a cross purchase is a viable business succession option. Without a new person to run the business, a stock redemption will not solve the problem of the sole owner’s departure.

7 One-Way Cross-Purchase Buy-Sell Agreement
Pool of Potential Buyers: Key Employee Relative Competitor Potential Buyer Prospective buyers may be a key employee, relative, friend or industry colleague, competitor or just an unrelated third party. Friend/ Colleague Unrelated Third Party

8 One-Way Cross-Purchase Buy-Sell Agreement
Buy-Sell Agreement contracts vary in terms, but all contain following mandatory provisions: 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 Buy-sell agreements are tailored to each client’s needs and circumstances, but all would contain certain mandatory provisions such as:The owner (or his/her estate) will sell to the specific buyer and the buyer will purchase the business interest from the owner.A price or formula to value the business has been agreed upon.The assets and liabilities to be transferred are specified. This is especially important for sole proprietorships. Since the sole proprietorship is not considered a separate entity from the owner or proprietor for tax purposes, the business’ assets remain the personal property of the proprietor and intermingled with his other assets. It is important to list out exactly which assets and liabilities are being sold and which retained to prevent conflicts at the time of the buyout.A means of funding, such as life insurance, is determined so that the buyer is capable of making the purchase.

9 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 more appropriate because: Triggering event for buyout often occurs for reason other than death (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 is available (gets too costly after a certain age) At time participants want to switch to permanent, insured may be in poor health or uninsurable. Sometimes the parties to the one-way cross-purchase buy sell agreement may seek to fund the agreement with term life insurance. Often this is their first choice due to the relatively inexpensive cost of term premium, as well as the ease of obtaining coverage. However, there are many instances where permanent insurance is the better selection even when it is not obvious at first blush. Some reasons why a permanent policy with cash value may be better include:Not all buyouts occur at the owner’s death. Many other reasons trigger a need for a new owner, such as disability, retirement, or just a specified date. With a permanent policy, the buyer would have access to the cash value to help fund a buyout occurring at a time other than the insured’s death.For long-held well-established businesses, permanent policies work best because the length of the agreement may extend beyond the time where term insurance is either available or inexpensive. Many carriers do not provide term coverage after a certain age, such as 80 years, or if provided the premium is so high as to be cost prohibitive. If the parties to the agreement try to obtain term first with the idea they will switch to permanent coverage later, that may be a risky gamble. You never know when illness may strike and the insured becomes uninsurable or Table rated.

10 Key Executive as Buyer – Executive Bonus
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) Sometimes, when the buyer is a known or related party, such as a key employee, an executive bonus plan or split dollar arrangement can be implemented to help him or her pay the premiums. Read rest of slide.

11 Executive Bonus: Here’s How it Works
Bonus Payment: Employer makes taxable bonus payment to executive and receives corresponding income tax deduction.1 Executive reports bonus as additional income. Life Insurance Employer 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. Here's How It WorksStep 1: Purchasing the Life InsuranceThe executive purchases either a fixed or a variable universal life insurance policy from Transamerica on the life of the business owner. Executive is the policy owner. The executive names himself as beneficiary. Step 2: Bonus Incentive IncomeThe life insurance policy premiums are paid as a bonus to the executive. Since the executive may incur a tax liability from the premium bonus, the company may also pay the executive additional cash to offset tax liability. For the company, the bonus paid under the Executive Bonus Plan is generally income tax deductible as compensation. Step 3: Accessing the BenefitThe executive can use the policy's accumulated net cash values to help fund a lifetime buyout of the business. Policy withdrawals or loans may affect the death benefit of the policy. In the event of the owner’s death, the executive will receive a federal income tax-free life insurance death benefit, which he will use to purchase the owner’s business interest. Executive 1 Provided amount of bonus is reasonable and employer retains no ownership rights or beneficial interest in the policy. 11

12 Using an Escrowed Buy-Sell Arrangement
Setting up the buy-sell agreement with an Escrow as intermediary can 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) In order to ensure that the sale will go through at the time of death and the buyer will not unilaterally back out, some owners set up the one-way buy-sell agreement with an escrow agent as the custodian of the life insurance policy. In such instances, the buyer is subject to restrictions on his or her ability to access the cash values of the policy. Once the owner dies, the death benefit is paid to the escrow agent, who ensures that the agreement is enforced.

13 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 Let’s say Felix owns a cleaning service organized as a sole proprietorship. If Felix were to die, his business would be forced to liquidate, since as a sole proprietorship, it cannot continue without an owner. Felix is concerned for his family, as he is the primary breadwinner. He wants to make sure his wife and children will have either a stream of income or lump sum replacement value of the business if he should pass away. Felix’s Cleaning Service Felix, Sole Proprietor

14 How it Works Example – Felix’s Cleaning Service
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. Felix decides to negotiate a one-way buy sell with his key employee, Oscar. Oscar started out as one of the worst cleaners, but over the years has worked his way up to being the best employee. Felix agrees to an employee bonus for Oscar to help him purchase a life insurance policy to fund the buyout. Oscar, Head Cleaner Key Employee

15 (Felix/Felix’s Estate)
How it Works Diagram – Felix’s Cleaning Service I. During Felix’s Life: Sole Proprietorship (Cleaning Service) Sole Proprietor (Felix/Felix’s Estate) 2) Employee Bonus/ Employer Deduction 1) Buy-Sell Agreement 1) Felix negotiates a one-way cross-purchase buy sell with his Key Employee, Oscar.2) Felix agrees to an employee bonus for Oscar to help pay premiums. Felix, through the cleaning service, can take a compensation deduction for the bonus when made. 3) Oscar must pay income tax on the bonus. If the income tax liability is too large for Oscar to pay, Felix might consider making a double bonus, which is a bonus with extra to cover the additional taxes.4) Oscar uses the after-tax bonus proceeds as premiums for a policy insuring Felix’s life. Premiums for the life insurance policy are not tax-deductible. 3) Income Tax on Bonus 4) Premiums IRS Transamerica Policy (on Felix) Buyer (Oscar - Key Employee)

16 (Felix/Felix’s Estate)
How it Works Diagram – Felix’s Cleaning Service Sole Proprietorship (Cleaning Service) Sole Proprietor (Felix/Felix’s Estate) II. At Felix’s Death: 8) Income Tax on IRD 7) Business Interest 6) Sale Proceeds 5) At Felix’s death, Oscar receives the policy proceeds. 6) Oscar uses the income tax-free death benefit to purchase the cleaning service from Felix’s estate. The policy proceeds are transferred to the estate. 7) In return, the business interest is transferred to Oscar. His basis in the business is the amount he paid to the estate. 8) Felix’s estate gets a step-up in basis at death to fair market value, however this does not include income in respect of a decedent (IRD), such as accounts receivables and notes. The estate will pay income tax on the portion of the sale attributable to IRD. After the sale is complete the Felix’s family will no longer own an interest in the cleaning service. 5) Death Benefit IRS Transamerica Policy Buyer (Oscar - Key Employee)

17 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 Generally, the policy death benefit will be federal income tax-free. Although the business owner has gain in the business (selling price less basis adjusted for depreciation) at the date of death or, if used, the alternate valuation date, the estate assets receive a basis stepped-up to fair market value. Thus, if the sale occurs within a short time after death, there would likely be no capital gain recognized on the sale. If the assets included income in respect of a decedent – such as notes, accounts receivable, commissions received after death or substantially appreciated inventory – then these assets don’t receive a stepped-up basis; and ordinary income may also need to be recognized as a part of the sale. This extra tax may be considered when the parties are setting the price of the business in the buy-sell agreement negotiations. If the buyer predeceases the owner, the value of the life insurance policy would be includible in the buyer’s estate.

18 Effect of Estate Basis Step-Up
Lifetime Sale versus Estate Sale The 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 Sale If 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 $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 Felix’s decision to sell the business at death rather than during life may have saved his family a lot of money. When Felix passes away, the assets in his estate receive a step up in basis to the fair market value at either the date of death or an alternate valuation date. This step up in basis helps to reduce any possible capital gain the estate would have to recognize on the sale. This chart is a comparison of the tax consequences of selling a business during life, or at death. The stepped-up basis usually acts to make a lifetime sale less profitable. This is just one factor to consider in making the succession plan. The owner should consider other reasons why a lifetime sale may be the best choice for him or her, such as a need to retire, poor health, future of the business’s industry, etc.

19 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 Sole Owner Offer to own business Funding (life insurance) to pay purchase price Basis in business interest equal to purchase price What are the Advantages?A buyer is identified ahead of time, preventing a loss of the business or a fire sale. This is especially important for licensed professionals.Value of the business for estate planning purposes has been set and agreed upon.The sale proceeds replace the value of the business as well as the lost stream of income for surviving family members.Life Insurance provides a guaranteed means of liquidity to enable the buyer to make the purchase at the needed time. An escrow arrangement can be used to ensure enforcement of the arrangement.The decedent’s estate gets a step-up in basis, eliminating or reducing the amount of tax due upon the sale.The buyer has a basis in the business equal to the amount of the purchase price. Key Executive/ Buyer

20 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

21 Business Succession Planning for the Sole Owner
One-Way Cross-Purchase Buy-Sell Agreements Business Succession Planning for the Sole Owner OLA

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