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 estate planning documents that business owners should have – providing for the smooth transfer of a business and establishes a fair price for the business interest.
Life insurance is typically used to provide tax-free proceeds to the business to fund the purchase of the deceased’s shares. A properly designed insurance program can often fund the solution for approx. 0.5 to 3.0% of the potential liability (or coverage amount).
Otherwise, the cost of an unfunded buy-sell agreement can have a devastating impact upon the operation of the business. Let’s look at an example for a large manufacturing & processing firm (not eligible for the federal small business deduction).
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 26.5% (range of 17.5% – 31% for 2023)
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 1st year is $300,000 (assumed to be deductible)
- the principal payment of $1,000,000 is not deductible and must be paid with corporate after-tax dollars
- the combination of these factors, at a corporate tax rate of 26.5%, translates into a need to earn approx. $1,661,000 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. $8,303,000 in sales to net out the $1,661,000 needed for the payment
Incredibly, gross sales must increase by a total of approx. $38,514,000 over the entire 5-year repayment period just to meet the bank loan obligation.
Fortunately, much of the financial stress could be mitigated by simply securing a $5M life insurance policy on the partner for an extremely modest outlay paid by the business. This cost-effective solution is far more palatable and manageable 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 your questions.
1 800 668-5901 x 3058
