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A key component of an integrated financial plan is planning for business succession. The business interest often accounts for a substantial portion of the wealth the business owner has accumulated.
Ensuring that a plan is in place for the eventual transfer of the business interest will help the owner realize full value for the business interest and it will also help the business and the remaining owners survive the transition.
This is particularly true if one of the owners dies prematurely. Changes in ownership may create financial obligations for the remaining owners. Ownership changes can also have income tax implications for the withdrawing owner and the owners who remain. An integral part of any succession plan is to ensure that financing is in place to fund the purchase and sale of the business interest if an owner dies.
The succession plan should also provide the business owner with sufficient liquidity to fund the related income taxes and, where possible, take advantage of any tax deferral or tax minimization strategies that may be available. For closely held corporations or partnerships, one of the most important tools for implementing a business succession plan is the shareholders’ agreement or partnership agreement. Once the business succession plan is developed, an agreement can be drafted to reflect the needs and wishes of the various parties. Life insurance is generally an efficient way to fund the obligation that results from a buy/sell agreement when a shareholder or partner dies. There are numerous possible ways to structure a buyout on death and life insurance funding plays an important role in ensuring the buyout occurs. In considering the various methods for structuring a buy/sell agreement, you need to keep in mind that there is no “right way” to proceed.
Each method has its own pros and cons and must be considered in light of the circumstances of a given situation. An important consideration is whether to fund the buy/sell arrangement with ‘corporate owned’ or ‘personally owned’ life insurance. Ensuring that the ownership is properly arranged from the onset will avoid a transfer of ownership in the future, which would result in a disposition of the policy and could possibly trigger a tax liability.
Funding Capital Gains Tax on a Business at Death Life insurance can also be an effective way to fund the tax liability that arises at death. An individual who owns shares in a corporation, a partnership interest, or business assets (as in the case of a sole proprietorship) will be deemed to have disposed of these properties at death.
As a result, a tax liability may arise in the form of capital gains and recaptured capital cost allowance. If funds or other assets are not available to pay the tax liability, the shares or partnership interest may have to be sold, or business assets may have to be liquidated, possibly for a price below the fair market value. Life insurance can provide the funds needed to pay the tax liability that results from the capital gains and recaptured depreciation triggered by an individual’s death.
Life insurance is a particularly valuable funding vehicle if the beneficiaries want to retain the property or if the market conditions will not provide the estate with an amount equal to the fair market value of the property. The individual could own the life insurance policy, or it could be owned by the corporation or partnership and dispersed to the individual’s estate after death.