DISABILITY BUY/SELL NEEDS

More businesses are owned or controlled by small groups of individuals (closely held businesses) than are publicly held. Closely held businesses range all the way from a proprietorship, comprised of only one worker who is both “boss” and the sole “employee” to a large industrial corporation, with thousands of employees. Where a business is closely held, be it large or small, there are substantial problems generated by the disability or death of a principal owner, which must be faced.

• Proprietorship Considerations

In the normal course of events, the disability or death of the sole proprietor will often sound the death knell of the business unless plans are made in advance to avert this crisis. A sound approach to the problem will likely encompass plans for the sale of the business at such time to a key employee, several key employees, or even to a competitor in the same line of business. The advantages of such a plan are many. The employees of the proprietor do not find themselves suddenly out of work. The spouse of the proprietor is relieved of the task of attempting to continue the business and funds are provided for family support. Most important of all, the business is not sold at a sacrifice - as might otherwise be the case.

• Partnership Issues

Disability is a consideration in a partnership, just as it is in the sole proprietorship. An important distinction is that disability does not terminate a partnership, as death does. The surviving or nondisabled partner may be ready, willing and able to carry on the business. However, hiring a replacement for, and continuing to share profits with, a disabled partner can be an overwhelming burden for a partnership.

• Corporation Complications

The corporation, being an artificial creature of the law, is unique when compared to the proprietorship or partnership. It is a separate legal and tax entity that does not terminate upon the disability or death of one of the owners.

A stockholder may feel, “my business will provide financial security for my family.” However, this is simply not true in most instances. Unless a spouse intends to replace the disabled or deceased stockholder as an active employee or a majority voting control is held so that the payment of dividends can be required, the disabled owner has no superior right to earnings or profits. In addition, there is no guarantee that the business will continue to make profits after being deprived of the abilities of the disabled or deceased stockholder.

Without special agreements, a corporation may not simply continue the salary of a disabled employee/shareowner. This would constitute an “employee benefit plan” and require similar benefits be paid to all other employees despite their period of service or position.

• Business Loan Endorsements

Banks traditionally require that key individuals personally endorse (guarantee) the loans. The fine print of the Loan Agreement usually provides that upon the death of an endorser, or any material change in the business (such as disability of an endorser), the bank can make the decision to call its loan. This puts added stress on both the business enterprise and the family.

PLANNING FOR THESE CONTINGENCIES

Accordingly, many of the same economic and practical problems that arise under proprietorship and partnerships are equally resolved by corporations through the use of funded buy/sell agreements. As in the unincorporated business, the transfer of ownership at disability or death to the surviving or active owners (cross-purchase) is feasible.

It is possible, in most states, to have the corporation itself purchase the stock, thereby placing control with the surviving or active stockholders. In addition, the decision to use either the corporate redemption or the cross-purchase need not be made until disability or death occurs (optional buy/sell). All of these routes seek to achieve the same goals as were noted above.

TYPES OF ARRANGEMENTS

The types of arrangements suited for use in the buy/sell area are as varied as the situations presented. For this reason, this discussion merely attempts to cover broad categories of agreements. Expert counsel is necessary to tailor both the discussion and the forms to a particular set of facts.

SOLE PROPRIETORSHIP AGREEMENTS

In the sole proprietorship situation, the term “Business Continuation Agreement” is perhaps the best descriptive phrase that can be applied to the arrangement. In the Business Continuation Agreement, the proprietor and the prospective buyer (usually an employee) enter into a contract that mandates at disability the proprietor shall sell and the buyer shall buy the business at a price agreed upon in advance.

Insurance on the proprietor provides an excellent method of funding the agreement. The provisions of the agreement must be tailored to meet the various contingencies that can arise in the situation presented. The provisions included in a typical Business Continuation Agreement will not cover all events that can arise, nor, in certain situations, will all of the suggested provisions be desirable.

PARTNERSHIP AGREEMENTS

Partnership buy/sell agreements usually take one of three basic forms. A Partnership Cross-Purchase Agreement contemplates an agreement binding the partner or partners to purchase the interest of the disabled partner.

It is best adaptable to situations involving two or, at most, three partners. The reason for this is that where more than three partners are involved, the funding of such an agreement by insurance becomes quite involved as each partner must plan upon the possibility of having to purchase the share of any of the other partners.

With two partners involved, this usually necessitates only two policies. When three partners are involved, six policies are in order. Four partners would require twelve policies and the number rises rapidly after that. Joint ownership of policies is usually not the best solution. Where more than three partners are involved, a partnership Cross-Purchase Agreement with a Trustee is usually desirable. Even here a number of variations are possible.

The trustee may be present only to ease administrative procedures when the time arrives for the buy out, or the trustee may occupy a more central position in the plan, actually holding ownership of the policies. When the trustee owns the policies, only as many policies are needed as there are partners.

The third basic form is a Partnership Entity Purchase Agreement that is an agreement to have the partnership itself purchase the interest of the disabled or deceased partner. Insurance owned by the partnership can be utilized to fund the purchase.

Partnerships composed of professional people can present special problems. Here tangible assets represent only a relatively small proportion of the total value of the partnership. Section 736 of the Internal Revenue Code of 1954, as amended, is a key factor in determining what type of buy/sell arrangement is best suited to a professional partnership. A special agreement, the (Professional Partnership Entity Purchase Agreement) is especially tailored for the professional partnership.

Most states have enacted statues permitting professional groups to form corporations or associations. The intent of the statues was to place the professional groups in a position where they could utilize the various fringe benefits which are associated with corporate status, e.g. pension or profit sharing plans, salary continuation plans, group insurance and accident and health plans. If such groups can satisfy the requirements of the Internal Revenue Service for taxation as a corporation, they may utilize corporate forms of buy/sell agreements.

CORPORATION AGREEMENTS

Corporate buy/sell agreements can be broken down into categories similar to those of the partnership agreements. A Corporation Cross-Purchase Agreement thus would be one providing for sale of stock by the disabled stockholder to the other stockholders. The corporation is not bound by this agreement in any manner. Where many stockholders are involved, a Corporation Cross-Purchase Agreement with Trustee would be desirable.

In a manner somewhat comparable to the Partnership Entity Purchase Plan, a Corporation Redemption Agreement provides for purchase (redemption) of the disabled stockholder’s shares of stock by the corporation. The funds are paid from the earnings and surplus of the corporation. The requisite amount of surplus can be obtained by having the corporation own insurance upon the stockholders.

Some states restrict the power of corporations to purchase their own stock. The purchase must not impair the corporation’s capital nor render it insolvent. The possibility of intervention by creditors of the corporation must also be considered. If insurance benefits have just produced a surplus, and if those benefits are assigned to the terms of an agreement, there will be no bar to the stock purchase.

There is a third variety of buy/sell agreement referred to as the “Optional Buy/Sell” (sometimes entitled the “Wait and See Buy/Sell”). The “Optional Buy/Sell” has tremendous flexibility in that a decision to use either the Corporate Redemption or the Cross-Purchase need not be made until death or disability occurs.

The agreement is funded with insurance or a cross-owned basis either individually, where two stockholders are involved, or through a Trustee, where three or more stockholders are involved. At the early disability or death of a stockholder, the corporation has a first option to exercise a full or partial stock redemption. Corporate surplus to exercise such option is obtained by stockholder contributions to capital or loans to the corporation from the insurance proceeds.

If cross-purchase is deemed appropriate, then the corporate option is passed and the stockholders are bound to purchase from the disabled stockholder or deceased’s estate. Of course, the insurance proceeds have been distributed to them (or the Trustee) and the purchase is easily accomplished.

INCOME TAX CONSIDERATIONS

There is a considerable difference, from the income tax perspective, between a purchase by the corporation or by other shareholders.

• Taxation to the Seller

If the shareholder is deceased, the stock takes a stepped up basis at death. If the sale is consummated soon thereafter there is no tax. If the purchase is due to disability, the shareholder’s taxable income may be reduced, thereby minimizing the tax impact.

• Tax Impact to the Purchaser

If stock is purchased (redeemed) by the corporation it returns to treasury stock. The value of the outstanding shares is correspondingly increased - but with the original cost basis. However, if the shareholder purchases the stock (rather than redemption) the cost basis is increased. This will reduce tax liability upon later sale.

VALUATION OF THE BUSINESS

One of the important problems in designing buy/sell agreements is to provide for a realistic purchase price. In proprietorships and partnerships, valuation of the business can be extremely difficult. With a closely held corporation a ready market by which to value the stock is, by definition, unavailable.

The normal approach is to provide in the agreement an initial value to be assigned to the business and to further provide means by which this value can be revised periodically, as time passes. If an unrealistic value is used, tax problems are likely to arise, especially if the buyers and sellers are related by family ties.

Because the human being is a forgetful species, it is often desirable to further provide that any valuation by the parties will be valid for only a limited time. If no subsequent valuation is selected, the value will be computed according to a formula (of which many types may be devised) or by independent appraisers.

Each agreement should contain language for the valuation method. If desired, the set-price method of valuation can be replaced by the appropriate alternative valuation formula.

DISABILITY AND THE BUSINESS OWNER

FACT: At all ages, the probability of a disability is greater than that death should occur.

FACT: Given four business owners with an average age of 45, there is a 90% probability one will suffer a long term disability of more than 3 months duration.

FACT: Less than 15% of all small businesses own a disability buy-out policy.

• The Disability Problem

A business associate is involved in an accident and becomes disabled. What happens to the business?

Chances are the active associate(s) will have to work harder and longer hours, and earn less. However, a bigger problem might be dealing with the sick or disabled partner. Freedom to make decisions may be limited by the disabled associate, who may now be concerned only with immediate and personal cash needs.

For the disabled associate, a significant portion of needed capital may be locked up in the business. During disability, since this person is no longer a productive employee, he or she would have little direct or meaningful control over this significant investment - the business. The disabled associate’s attitude may become one of anger and frustration.

• One Initial Solution

The potential conflict between the active and the disabled associates can be avoided by one simple solution - a Buy/Sell agreement. The agreement will provide for the acquisition of the disabled owner’s interest by the business of the active associate(s). Equally important, the disabled owner will receive a fair price that was determined in advance for the business interest.

In the buy/sell agreement, the parties are clearly identified, their obligations to buy and sell are carefully spelled out, and the price, or method of establishing the price, is specifically set forth.

The agreement should provide a clear definition of the period of time that must elapse before the purchase is mandatory. There should also be a definition of disability that would trigger the execution of the terms of the agreement. One advantage to using insurance funding is that the insurance company would establish whether a person is disabled before paying the benefits of the policy.

• The Ultimate Solution

The buy/sell agreement goes a long way in solving problems when an associate is disabled. Where does the money to effect the buy-out come from? Although this could present a very difficult problem, the solution is apparent: disability Buy-Out insurance. In this way, the situation that causes the problem (the disability) also provides the solution (dollars). Funding the buy/sell with a disability buy/sell policy insures that the funds will be available to execute the purchase.

BENEFITS OF A FUNDED BUY/SELL

1. An assurance that there will not be an indefinite drain of the cash flow and/or assets of the business in the event of a disability of a business associate.

2. An assurance that the business interest of a disabled owner is set at a fair and definite price.

3. An assurance that the active business owners will maintain voting control of the company.

4. Assurance of less dissention and conflict by reaching a decision as to “what’s fair” while all parties are able to negotiate without prejudice.

5. Assurance that active business owners can keep family members of the disabled owner out of the business and that only active owners will be able to participate in the future growth of the business.

6. Assurance that a competitor cannot purchase the business interest of the disabled owner, jeopardizing employees.

7. Continuity of management of the business, which in turn, makes the business more attractive to customers, creditors and employees.

8. The assurance to provide dollars without using future income or borrowing. These dollars can then be utilized to provide most of the purchase price, without disrupting the actual business’ cash flow.

BASIC TYPES OF DISABILITY BUY/SELL AGREEMENT

A Cross Purchase agreement is used to allow the active owner to purchase the interest of a disabled owner. Each shareholder, or partner, owns a policy on the other. This type of agreement is best suited when the business structure involves only two or three owners.

If a Cross-Purchase agreement is desired, but there are more than three owners involved with the business, a Trusteed agreement should be used. This merely involves the use of a trustee, such as a bank, to hold the policies and effect the buy out.

With an Entity Purchase or Corporation Redemption agreement, the business entity itself purchases the interest of the disabled owner. The entity, whether it is a corporation or a partnership, owns a policy on each partner or shareholder.

This type of agreement may be preferable in situations where there are three or more owners.

An Optional Buy/Sell (sometimes called a “Wait and See Buy/Sell”) allows the ultimate in flexibility and involves the least amount of speculation, since the decision of whether to cross purchase or redeem stock is postponed until after the disability of one of the business owners occurs.

The Disability Buy Sell insurance is normally owned on a cross purchase basis. If redemption is elected, the active associate(s) can contribute as capital, or loan, the insurance proceeds to the business.

DISABILITY BUY/SELL TAXATION

Premiums paid for Disability Buy/Sell Coverage are not deductible.
Benefits received from Disability Income insurance are not taxable.

Type of Entity Agreement Owner Step-up in Tax Basis*

Partnership Cross Purchase Partner Yes
Partnership Entity Purchase Partnership Possible
Partnership Trusteed Trustee Yes (if Cross-Owned)
Corporation Cross Purchase Stockholder Yes
Corporation Redemption Corporation No
Corporation Trusteed Trustee Yes (if Cross-Owned)

* By purchaser, when disabled shareholders interest is obtained.

WHY USE INSURANCE?

The death or disability of a key owner is always difficult, and without proper planning, it can mean financial disaster for both the business and its owners. Disability, unlike death, can mean double expense to the small firm. In the absence of an agreement, a partner or shareholder could continue to receive a share of partnership profits or salary. In addition, the business may have to hire a suitable replacement, thereby doubling expenses. Business owners will naturally want to protect their corporation or partnership against such a contingency.

Depending upon the value and the cash position of the business, it might be possible to use current cash or to borrow funds to provide the needed dollars for purchase of a disabled associate’s interest. However, from a monetary standpoint, using discounted insurance dollars guarantees that cash will be available when it is needed and that the future earnings or cash assets of the business will not be impaired. In addition, cash flow, and/or borrowing power present today, does not assure its availability in the future, especially if one of the key associates in the business is totally and permanently disabled.

Source: Society of Actuaries' DTS Experience Table