Guarantee shareholder value and eliminate buy-sell risk
There’s a tremendous need for life insurance to fund the buy-out agreement of two or more partners. This agreement is one of the most essential and important documents that business owners should have in their overall estate plan. This legal document not only provides for the smooth transfer of a business on the death of one of the business owners but if properly drawn, it also establishes a fair price for the business interest.
In cases where a business is incorporated, insurance has been used to provide tax-free proceeds to the corporation to fund the purchase of the deceased’s shares. The funding of a share purchase obligation with insurance is the most logical, expedient and often times the most inexpensive method currently available. Otherwise, the cost of an unfunded buy-sell agreement can have a devastating impact upon the operation of the business.
There is only one safe, simple and sure method of avoiding the inevitable conflicts arising on the death of a shareholder. Simply put, this type of corporate estate planning involves two steps:
- The execution of a binding buy-sell agreement between the shareholders, providing that the interest of the shareholder that dies shall be sold and will be purchased by the surviving shareholder at a value agreed upon by the parties and stipulated in the agreement; and
- The establishment of some sort of funding mechanism which will provide sufficient cash at the death of any shareholder to insure the prompt execution of the agreement and to guarantee that the surviving party will have the money to carry out this obligation.
While there are a number of methods to fund this potential liability, life insurance is the only one that cannot fail to provide the required cash immediately upon the shareholder's death. A properly designed insurance program can often fund the solution for less than 0.5 to 1% of the potential liability. Let’s look at the alternative for a metal fabrication firm.
Assumptions: if one partner dies?
- Remaining partner must “buy out” the deceased’s shares, currently valued at $5,000,000
- How will the partner raise the funds? Borrow, personal account, family and/or friends, bank manager?
- Arrange a $5,000,000 loan with the bank, charged 6% interest on the outstanding yearly balance
- Principal is to be repaid in equal installments over 5 years
- Gross sales to pre-tax earnings ratio of 5 to 1 – must sell $5 of goods or services to be left with $1 needed to service the loan (particular to this business)
- Corporate tax rate is 15% (qualifying small business rate in Ontario)
The mathematics are quite straightforward.
In the first year
- the total unfunded balance is $5,000,000
- with an interest rate of 6%, the charge for the year is $300,000 which is assumed to be tax-deductible as part of overall corporate borrowings
- the principal payment of $1,000,000 is not deductible and so must be paid with corporate after-tax dollars
- the combination of these factors, at a corporate tax rate of 15%, translates into a need to earn approx. $1,476,000 of net income before taxes to service the first year’s bank payment
- and further, using the gross sales to earnings multiple of 5, the business would need to generate approx. $7,382,000 in sales to net out the $1,476,000 needed for the payment
Incredibly, gross sales must increase by a total of approx. $33,900,000 over the entire 5-year repayment period just to meet the bank loan obligation which in-turn was negotiated to meet the survivor’s obligation to the deceased’s estate. To compound this monumental task, there will be one less significant contributor to this effort.
Fortunately, much of the financial stress outlined above could be mitigated by simply securing a $5M life insurance policy on the partner for an extremely modest outlay paid by the company.
Only buy-sell Life Insurance can guarantee that the same death that triggers the agreement will, in and of itself, provide the cash to carry out its terms and implement the contemplated purchase of the deceased’s interest. This cost-effective solution tends to be far more palatable and manageable budget-wise, than incurring an additional bank burden.
Whatever the value of a business, life insurance will guarantee that a shareholder’s family members will benefit from a solution that helps to create, preserve and transfer wealth in a tax-efficient manner.
If you have any question related to your estate plan or want to know more, please contact me and I’ll be happy to answer all your questions.
1 800 668-5901 x 3058