Last updated July 28, 2008
Every business owner who has partners involved in the business must take a break from the daily grind of running their business to plan for certain possibilities. Among these are premature death and disability while still running your business.
If we do not have a plan — a funded plan — to deal with both of these possibilities, there would be a huge burden placed on everyone involved: partners, family and self (if disabled).
If you die and the value of your share in the business is $500,000, how is your partner going to pay your family for your share? Or, if you become disabled and can never work or contribute to the company and your share of the business is $500,000, how is your partner going to pay you for your share of the business? It is important to plan for these possibilities.
In the event of a premature death while you’re still working, life insurance is the best way to protect your interest in the company.
In the event of a premature death while you’re still working, life insurance is the best way to protect your interest in the company. You can leverage the company assets by paying for life insurance that will pay your family for their share of the business. This is the most efficient way to pay for a death buyout. You can use term life or permanent life insurance. If you only need the pure death benefit for a defined period of time, not to exceed 30 years, for instance, term life is the best fit for you. However, if you want the life insurance to extend past a defined number of years, perhaps even after your interest in the company has ceased, a permanent plan may be the best fit.
The permanent insurance can also be used to enhance benefits to the owners and leverage premiums in a very tax-efficient manner. The business can fund the plan and simply add the premiums to the partner’s gross income. The net cost effect to the partner is the tax due on the premium amount paid by the company. The tax-advantaged cash value that builds up in the permanent policy can be used in the future for almost anything the partner wants: a car, college funding, a second home, retirement, etc. If done correctly, there would be no tax or penalty due on the amount withdrawn from the plan.
In the event of a disability, the company would need to buy out the disabled partner for his or her share of the company. This would usually take place after the partner has been disabled for a long time and is rather certain the disability is permanent — the period of time before the policy and buy out would kick in is usually a minimum of one year.
A disability buy-out policy is a great way to leverage the company dollar.
Some companies opt for an 18- or 24-month waiting period. Just as with life insurance, the disability buy-out policy is a great way to leverage the company dollar. If you became disabled and the partners were going to buy you out and your share of the company was worth $500,000, where would the money come from? The most efficient way to fund this is through the disability policy, using pennies on the dollar to fund the obligation. The buy out can be paid in a lump sum or monthly over a certain period of time, such as five years.
It is also very important to have a buy-sell agreement drafted by a professional that spells out valuation for the business and all other details of a buyout in the event of death, disability, termination or voluntary departure.
There are real dangers to a business if the disability or life buyout agreement is not done well. Imagine a scenario where your corporate buyout agreement agrees to a valuation of the business, you fund the current agreement with life and disability insurance for the buyouts, and six years later the value of the business is 10 times what it was when you agreed to the formula.
The agreement is underfunded by insurance, and now imagine one of the partners becomes disabled. When you signed the agreement you would have owed $250,000 to a partner who became permanently disabled. Now you owe $1.5 million and have only $250,000 of insurance. This scenario is too common, and one reason why it is very important to work with specialists for disability and life buyout agreements in partnerships.
Consult your business advisers, accountant and attorney on all these issues.
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