Agreements help ease business succession
Life insurance, as they say, actually concerns the alternative to life. And in the case of business partnerships or corporations, what happens to the business after one of the principals dies can be covered by a policy that ensures assets go where the deceased intended.
Such agreements also can ensure that a surviving family member doesn’t get caught with unexpected bills or responsibilities.
Contracts called buy-sell agreements can be linked to life insurance policies. In the absence of such agreements, a business partner’s assets in the company could automatically go to heirs at death.
“That might not be what the (surviving) partner wants,” said William Kain, a Grand Junction attorney who handles buy-sell agreements.
And it might not be what a surviving spouse wants, either. The spouse might know little about business operations and have no interest in becoming a partner. In such a case, the inheritance might become nothing more than another tax burden.
As an alternative, the partners can sign a cross-purchase agreement. Under this type of buy-sell agreement, each partner names the other as a life insurance beneficiary, with the agreement that the surviving partner will use the death benefit as a payment to a family member (usually a surviving spouse) in exchange for full ownership of the company. In the case of a spouse who’s not directly involved in the business, the spouse receives payment without the responsibility of running a business. The surviving partner receives the benefit of full ownership.
Because the payment to the family member is in the form of a life insurance benefit, the benefit is not subject to income tax. It’s also free of estate and gift taxes.
“If I sold you my half of the business (while still alive), I’d have to pay capital gains taxes of at least 15 percent,” Kain said.
As an example of a cross-purchase agreement, Kain said two partners could decide their business has a value of $500,000, and that a $250,000 insurance policy would cover half the value in the event of a partner’s death.
Should the IRS challenge the value of the business, a surviving partner could simply call the payment to a surviving spouse a gift. The IRS permits a person to give $1 million in gifts over a lifetime before gifts are subject to income taxes. Should the payment not be labeled as a gift, and should the IRS deem the business isn’t worth $500,000, the spouse would be liable for capital gains taxes on the portion that’s above the actual value of half the company. There’s some leeway in discussing the company’s value with the IRS. For example, the name of the company has a value that can be difficult to assess.
The cross-purchase agreement can also work in the case of limited liability corporations (LLCs), but the contract becomes more complicated as more people become involved.
A second type of buy-sell agreement is known as a redemption agreement. It can be more practical for businesses that feature several partners or hundreds of stockholders. Such an agreement can specify where the stock holdings end up in case of a stockholder’s death.
In the case of a corporation, the corporation could be the life insurance beneficiary, often securing the deceased person’s stock as a benefit. The corporation would then make payments to an heir to avoid tax burdens or forcing a share in the corporation on the heir.
“The alternative could be that 99 owners (or stockholders) would all have to take out life insurance policies on each other,” said Kain, which he said would be an unwieldy situation.
In any event, it behooves business owners to prepare for what might happen should they die while having partial ownership in a firm.