A common issue facing small business owners, and one that is not often planned for, is how to transition ownership of a small business upon the death of one of the owners. The most common form of small business now is the Limited Liability Company, or LLC. In an LLC form of business, the owners are called members, and each member usually owns a percentage of the business. Although less common, a small business can also be formed as a corporation, where ownership is divided into shares.
When a small business is formed, the owners usually fund the business by investing their own money, or by taking out a small business loan. During the early years, the owners will often make additional investments -or take out additional loans - to cover losses, and as the business grows over time and becomes profitable, the owners will share in the profits, usually in proportion to each owner's respective investment in the business.
As the revenue and profits grow over time, so to does the value of the business. Whereas the initial value of the business was equal only to the investments made by the owners, the value of a successful business can quickly grow into the millions of dollars, especially when profits and assets such as buildings, equipment, patents and/or trademarks are factored in. And while it is indeed great for the value of the business to grow, challenges arise when one of the owners dies and the spouse and/or other heirs of the deceased owner want to collect on their share of the business. The following example will help illustrate the challenges small business owners and their families face upon the death of one of the owners:
Let's assume that Dave and Bob start a software business, with each owning 50% of the company. Dave and Bob form the business under Michigan law as an LLC, and both invest $10,000 of their own money. They also agree to split any profits 50/50. Over the course of many years, Dave and Bob build a highly profitable business, based primarily on a software program that they developed that is used extensively in the medical industry.
After fifteen years in business, Dave dies very unexpectedly, leaving behind a wife and three children, as well as two mortgages and significant amounts of personal debt that helped fund his family's lifestyle. He also leaves behind a business partner who is now on his own running the business. Because Dave and his wife had a Trust in place, his wife is set to inherit his half of the business. Dave's wife, however, is a school teacher who has no interest in running a business. His three children are still living at home and are too young to help run the business.
Dave's wife decides that the only way for her to survive financially is to sell her share of the business, and Bob decides that he wants to buy Dave's half of the business, as opposed to selling his half or bringing on a new partner. The business is appraised at $5,000,000. In order to buy the business, Bob would have to come up with half that amount, $2,500,000. Bob's challenge is that he also has significant personal debt, and he cannot come up with enough cash to buy out Dave's wife. With no other choice, Bob decides to bring on a new business partner.
The example above is very common with small businesses, and one potential solution is to fund a Buy-Sell Agreement with Life Insurance. In this example, Dave would have taken out a life insurance policy on Bob's life, and Bob would have taken out a life insurance policy on Dave's life, with the proceeds to be used by the surviving owner to purchase the deceased owner's share of the business. As the business grew through the years, Bob and Dave could have increased the value of the policies. Bob and Dave also could have signed a Buy-Sell Agreement when they started the business, stating that upon the death of either, the business would be appraised and the surviving owner would have the first opportunity to buy the business. The life insurance proceeds on the deceased owner's life would then have covered most, if not all, of the purchase price.
In our example, if Bob had a life insurance policy on Dave's life, he could have used the proceeds to buy the business, thus avoiding the unwanted necessity of bringing on a new business partner. Dave's wife could have sold her share of the business to Bob, and she could have used the proceeds of the sale to pay off the mortgages, put her kids through college, etc.
One other advantage of using life insurance to fund a Buy-Sell Agreement is that the value of the insurance proceeds is not included in the decedent's estate for estate tax purposes. As long as the insurance policy was taken out on the life of the decedent, and the proceeds are used strictly as payment to the decedent's estate for his or her ownership share of the business, the proceeds are not taxable.
In our example, and for many small business owners, a Buy-Sell Agreement funded by life insurance is a great way to protect the surviving owner's interest in the business, as well as a great way to protect the family of the deceased owner. To learn more about this and other Estate Planning topics, please visit my website at http://www.toburenlaw.com/
