Fund Your Buy-Sell—In CURRENT Dollars
by Shel Horowitz
Family business Center sponsors Ron Weiss of Bulkley, Richardson and Gelinas, LLP and Charlie Epstein of Epstein Financial Services, teamed up to tell the FBC's March gathering that it's not enough to have a buy-sell agreement in place; it has to be properly funded, and that can be a moving target. Numbers that made sense years ago when the buy-sell was drawn up may be totally obsolete by now, so it's a good idea to go through a thorough evaluation every couple of years.
And while you're at it, review your life insurance, too. The term policy you bought at age 25 will be a lot more expensive to renew at age 55 or 65, and doesn't build any equity. Say Epstein: "96% of term insurance never pays a death benefit. When you get out into your 60s and 70s, the cost of that premium is going through the roof. So they cancel, and then they die. Term insurance is like takeout food. Permanent insurance is dining in. Permanent insurance includes some sort of investment feature.
You can say to the insurance co, I’ll give you more money so the cost doesn’t go up.
"You can set up whole life policies that generate 10%, tax free, and they’ve got the cash. You don’t have to die to win."
"You can’t do your business ownership planning separately from your estate plan. It’s your major asset," Weiss pointed out. He noted that not only does a buy-sell have to adapt over time, but sometimes it's harmful to even have one. "A buy-Sell agreement isn’t appropriate for everybody. There are reasons not to have them, and reasons you should have them.
A key question is "Who should own and operate your business if you die or if you leave? That question is critical to the well being of your family and of your employees.
The usual suspects-- spouse, children in the business-- will call for a careful drafted buy-sell and a well constructed estate plan. If you include children who do not work in the business as owners, there may well be family disputes over salaries, dividends, sale of the business, etc.
"Some decide to sell the business and divide the cash.
"Some people draft agreements with a set price, sometimes tied it to the amount of life insurance. Unless a set price is freshly determined, it’s not going to reflect reality. Also, a set price may not be honored for estate tax purposes. The IRS will want price to reflect fair market value in a sale to your children. In a sale to a third party, the IRS is generally willing to live with whatever arms-length price you set.
"We often see big fights when when an agreement calls for a set price that is subject to review every few years. Almost no one has the discipline to come back and review it, and the price often does not reflect current value. Usually, the value of the company has gone up at least from inflation. You get arguments that the decedent agreed orally on a higher price. A set price subject to periodic review is generally a bad idea.
"A formula price is OK if it reflects fair market value.
"A valuation that utilizes an appraisal may work if the price you want is based on fair market value."
According to Epstein, you need some good planning and hard answers:
"Could the business generate the extra cash? Typically, in a buy-sell, the payback will be over several years—but then there’s interest on it, and I have to generate the money for after tax. So if you need a million and a half, you must generate 2.5 million to cover the taxes. Are you in business for the short term or the long term? Are there additional purposes of this insurance?
And a buy-sell isn't the only factor, says Weiss. "A lot of small companies put a right of first refusal into their charter. That ordinarily shouldn’t be there if there is a buy-sell agreement in place. If it’s there, make sure whatever buy-sell you put in place isn’t impeded. A right of first refusal may or not be part of any well thought-out arrangement. A buy-sell often deals with things other than death: termination of employment, disability, or someone just wants to sell shares. Without considering the right of first refusal that may have been included in your charter, what you may have bought yourself is a lawsuit over who will own the business."
But that, both Epstein and Weiss agree, can be avoided with proper planning and expert advice.