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When business owners are asked to consider their business succession plan, they often mistakenly think this means taking steps to secure the future of their business should they die or become disabled unexpectedly.  While this is important, it is more likely someone will leave their business voluntarily through a transfer to family members, key employees or via a sale to an outside party.  Succession might even mean winding the business down. 

A planned or unplanned departure from one’s business can be made easier by preparing for an exit.  Unfortunately, a minority of business owners have made preparations.  According to PwC’s 2021 Family Business Survey, only 34% of family businesses have a documented and communicated continuity plan in place.  Conversely, a recent survey by BEI reports that 56% of business owners want to sell or transfer their ownership within the next ten years. 

The succession planning specialists at The Cowart Group can help closely held businesses plan for an orderly transition upon a timed or untimed triggering event such as the death, disability, retirement or withdrawal of any of the business’s shareholders, owner or business partners.

Working Toward a Buy-Sell Agreement

A “best practice” for exit planning involves a team of collaborative advisors working together to identify what possible opportunities and obstacles a business owner’s plan may encounter.  These discussions commonly lead to developing the terms for a buy-sell agreement, which documents and identifies the triggering events, valuation methodologies, payment terms, etc.  Many businesses look to future cash flow as a way to fund a buy-sell strategy…but is that the most efficient method to purchase the interest in the case of a deceased or disabled owner?

For buy-sell plans triggered by disability and death, life insurance is often part of the solution since it provides an immediate income tax-free source of capital when a business needs it most.  Proceeds received from life insurance may provide estate liquidity to offset debt, expenses and taxes.  It may also provide a valuable income stream for loved ones.

When using life insurance to fund a buy-sell agreement, business owners generally choose between one of three plans:

  1. Cross-Purchase Plan
  2. Entity Redemption Plan
  3. Hybrid Plan

When addressing the disability of an owner, separate disability policies may be purchased under each of these plans or the cash value from life insurance policies may be tapped to meet the obligation.

Exit Sign

Cross-Purchase Plan

In a cross-purchase plan, each owner purchases a life insurance policy on the other owners.  Then, when an owner dies, the remaining owners use the payout from the life insurance policy to buy the deceased owner’s share of the business.  These purchasing owners receive a full step-up in basis.  As part of a cross-purchase plan, the departing owner, or the owner’s estate if they die, is obligated to sell their interest to the company. 

These arrangements are fairly straight-forward if there are two or three owners but, as the number of owners increases, so does the complexity of the plan due to the number of policies required.  One way to address this complexity is to have a trust or a partnership acquire the policies on the lives of each owner, with each owner having his or her pro rata ownership in the trust the same as the ownership in the business entity.

The Cowart Group can help business owners and their advisors evaluate if a cross-purchase plan makes sense and how life insurance can be optimally positioned to fund exit contingencies.

Entity Redemption Plan

An entity, or stock, redemption plan is where each owner enters into an agreement with the business to sell their interest to the business.  The company then purchases a life insurance policy on the life of each owner.  When an owner dies, his or her shares can be redeemed by the company using the policy’s income tax-free death benefit.

If an owner were to leave the business, the company can use the cash value from the policy to help purchase that owner’s interest.  The company could also give the policy on the life of the departing owner to the owner as full or partial payment of the owner’s interest.  The policy could then be used by the departing shareholder in estate or future income planning.

Under an entity redemption plan only one policy per owner is needed and the cash value of the policies is recorded as a business asset.  However, there is not an increase in basis for the surviving shareholder and, if family members are involved, IRC §318 may create special tax problems that should be considered.

The Cowart Group can help business owners and their advisors evaluate if an entity redemption plan makes sense and how life insurance can be optimally positioned to fund exit contingencies.

Hybrid Plan

A hybrid plan is also known as a “wait-and-see” plan as it allows business owners to postpone the choice between a cross-purchase plan and an entity redemption plan until the occurrence of a triggering event.  In a hybrid plan, both the business and the owners agree to purchase the interest of a departing owner.  Usually, the business has the first option to buy the interest with the other owners having the second option to purchase the interest, or any remainder of it.  Then, the business must buy any non-purchased interest of the departing owner.

Each of the individual owners and the entity are potential life insurance buyers.  The business has the greatest exposure since it has a binding obligation to purchase the interest if the two options are unexercised, or incompletely exercised.

The Cowart Group can help business owners and their advisors evaluate if a hybrid plan makes sense and how life insurance can be optimally positioned to fund exit contingencies.

Make An Orderly Exit

Let’s go to work together to plan for an orderly transition for the owner of a closely held business.  The financial professionals with The Cowart Group provide tailored financial solutions to families and businesses that count on our experience and dedication to their success.  Our aim to deliver quality advice derives from our relationships with insurers, our underwriting advocacy, and technology resources.  We provide strategies and solutions designed to assist our clients in benefiting from and optimizing existing and changing government regulations.