In last month’s column, I discussed the importance of reviewing buy-sell arrangements and the funding for those arrangements.
This month, we’ll look at what the structure might look like. Although many advisors or other professionals may have their own biases, a needs-based, client-centric approach is best for all to start with.
Consider the case from last month, Jones Manufacturing, founded by two unrelated shareholders, Franklin Jones and Bradley Armbruster. A myriad of solutions could end up providing capital to buy out the shares of a deceased or disabled shareholder. Many times I’ve seen advisors recommend a solution on a tax-related concept before understanding what shareholders like Franklin and Bradley want to see happen to their business. Attention may then get focused on the taxation aspects of the premiums or benefit payouts, and tax treatment to the purchaser and the seller.
That approach may create an efficient end result but it will not create the flexibility Franklin and Bradley will need for their changing business. Instead, successful advisors will start with a series of simple questions that isolate the client goals and then explore efficient means of structuring coverage as a second phase. For simplicity’s sake, we’ll assume that Jones Manufacturing is worth $6 million and that death rather than disability occurs.
Here are some questions you need to ask.
1. What is the ownership structure of your business?
Getting the clients to draw a diagram may be the simplest way to help you understand this. Perhaps Bradley and Franklin have a simple structure where each of them personally owns half of Jones Manufacturing. However, there may be multiple operating businesses, and they may own their shares in the operating businesses through “holding companies” that do not operate a business day to day; they may simply hold shares in the other businesses or other investments. An additional complication could be ownership via family trusts. In any case, you’ll need to comprehend the business structure to understand how and where to structure the funding for the ultimate buyout of shares.
2. Do you currently have an agreed-upon buyout structure in your shareholder agreement?
If yes, then what is your understanding of how that buyout would take place? If no, then, can you describe how you would like to see a buyout take place?
Without going into all the complexities, there are two basic ways for a buyout to happen.
Option A is for the surviving individual to purchase the shares from the estate of the deceased shareholder (or the shareholder’s spouse). The individual makes the purchase with insurance proceeds received either directly from the insurer, or via payment created by insurance from one of his or her corporate entities. (Death benefits from life insurance create capital dividend account credits for any funds in excess of the adjusted cost basis of the policy. These amounts can be paid out tax free to shareholders.)
Option B is for the company to purchase the shares from the estate or spouse, and then cancel those shares. The survivor’s share value would then represent 100% of the value of the company.
Franklin and Bradley may have no preference for which option is used for the buyout, as they both create the buyout mechanism. Oftentimes, other considerations such as tax efficiency for each party, simplicity and flexibility drive the solution.
3 (a). Where are the dollars to pay for the premiums? Are they in your personal hands, or in one of your companies?
Franklin and Bradley could pay either personally or corporately, but are slightly more in favour of corporate payments so they both know that each other’s coverage is in place and paid every year.
3 (b). How important is tax efficiency of premium payments to you?
Clients often ask if they can deduct their life insurance premiums, but other than in some rare exceptions, they cannot. With corporate tax rates being generally lower than personal rates, it’s often more efficient to use corporate dollars to pay non-deductible expenses.
4. From a tax perspective, are you looking to provide the most tax-efficient solution to the deceased or the survivor, or a balance between the two?
Most clients will not realize that there may be different tax results arising from different structures, which may favour one or the other party.
Many family businesses tend to choose to defer taxes as much as possible. For unrelated parties, they often decide to balance tax treatment for both the deceased and the survivor. Depending on these priorities, any of the above described structures can create different tax consequences. It is important to ask this question before going into the specifics of any one solution. This way, value is delivered in a customized fashion to their specific needs only after they’ve told you the general parameters.
Through the simple discovery of answers to these questions, what can be a complicated and onerous process is distilled down to the essential elements. You will now know the ownership structure of their business, and whether they have an up-to-date buy-sell agreement. You will know where they should own the insurance: either personally or corporately. You will know where they will pay for it: generally the same place. And you will definitely know how they prefer to see their ultimate tax consequences handled.
Next month, in the last part of our buy-sell series, I’ll explain which solution Franklin and Bradley ultimately picked.