An all-too-common reason family businesses don’t endure is lack of succession planning.
By Michael Olivia, CFP, CExP
Nearly 90% of businesses in North America are family-owned or controlled, according to the U.S. Census Bureau. While many of these business owners plan to pass on their companies to their families when ready to retire, just over 30% make it to the second generation, and even fewer make it to the third (12%) or fourth generations (3%).
Preparing for succession is the number one challenge family businesses face.2 The onus is on business owners to plan carefully and early to protect the future of the company and allow for an efficient and financially feasible succession. A lesser-known but very effective deployment of whole life insurance can help a business owner ensure their company gets handed down successfully and offer financial protection for family members through a death benefit.
Insurance as an estate equalizer
An important way whole life insurance can play a role in business succession is by acting as an estate equalizer. Though parents often wish to pass their business on to their children—85% of family-owned firms that have identified a successor say it will be a family member2— it’s common to find that some children don’t want to be involved in the company. When the business gets split evenly among heirs, conflicts can arise between children who are active participants and children who are inactive but may still reap the financial rewards. If a parent knows not all children want to be involved in the business, a whole life insurance policy can provide an alternative benefit to compensate disengaged children while interest in the business gets passed to active participants.
For example, a business owner can leave instructions to conduct a business valuation, leave 100% of the business to the children who wish to or are qualified to take it over, and count on the value of pre-planned whole life insurance to compensate non-active children in an equivalent amount – leaving any additional proceeds to be split evenly. Each child would receive the same financial benefit, but in different forms. That avoids a common source of friction in splitting ownership interests evenly between children. As an additional benefit, the whole life insurance policy owner has access to the cash value during their lifetime, as long as premiums are paid, and can utilize it as needed should their plans change.* Further, a death benefit is always present if an owner unexpectedly passes.
A similar and equally effective way to ensure a successful business succession is to set up an Irrevocable Life Insurance Trust, where the trustee is an individual other than the business owner or their children. In this scenario, the trust is managed professionally with strong creditor protection, and the business owner is still able to control when the beneficiaries receive proceeds from the policy.
Life insurance-funded buy-sell agreements
Buy-sell agreements are another sound succession planning strategy that remove potential unwanted or unqualified family members from a business’ operations, provides liquidity to a deceased owner’s family for estate purposes, and protects owners and family members from forced liquidation of a business. They can be thought of as “business prenups” or “business wills” that protect a business, its owners and heirs. They are written legal contracts that specify what happens to a business interest when an owner is disabled, dies or leaves the business, voluntarily or involuntarily. They help keep the business running for remaining owners when heirs are not interested in keeping the business, by buying out the deceased owner’s share from those heirs.
Each owner buys a life insurance policy on the other owners. The buy-sell agreement will establish a ready market to purchase a business interest; establish a value for the purchase price of the business interest; identify the future buyer(s) — typically co-owners or key employees; identify the events that would trigger the buy-sell agreement; create a legal obligation for the departing owner to sell his or her business interest, and a legal obligation for the buyer to purchase the interest; and provide a source of funds necessary to make the buy-sell arrangement effective. When an owner is disabled, dies or leaves the business and the heirs have no interest in taking over, the remaining owners can get the death benefits from the life insurance policy.
Additionally, if a business owner retires, a life insurance funded buy-sell agreement can be leveraged for part of the business owner’s exit. It’s an additional layer of retirement planning for a business owner that also acts as an integral part of succession. Other benefits include the fact that life insurance may be creditor protected, so if the business is ever sued, then the policy may be protected from those threats.** Funding a buy-sell agreement with whole life insurance is uniquely flexible way to plan for succession.
Insurer structure matters
When buying a life insurance policy, business owners should understand an insurance company’s structure. Mutual companies are owned by participating policy holders, which aligns the interests of the company and the policyholders. Mutual companies tend to manage for long-term financial strength to meet their benefit promises as well as distribute profits to policyholders, such as through an annual dividend. The dividend, though not guaranteed, can be reinvested tax-free into a whole life insurance policy to increase its value.***
Ultimately, a business owner wants to protect two things – the longevity of their business and their family’s financial security. A whole life insurance policy is a valuable asset to include in a business owner’s financial portfolio, especially when thinking about how a business should be passed on to future generations or buyers. Business owners have unique financial considerations that require thoughtful succession planning – working with a financial professional, particularly those certified in exit planning, can provide in-depth strategies for leveraging life insurance policies to help business owners and their families achieve financial security for the future.
Michael Olivia, CFP, CExP, is with WestPac Wealth Partners in La Jolla, CA.
*Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59 ½, any taxable withdrawal may also be subject to a 10% federal tax penalty.
** State creditor protection for life insurance policies varies by state. Contact your state’s insurance department or consult your legal advisor regarding your individual situation.
***Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. Dividends are not guaranteed. They are declared annually by Guardian’s Board of Directors.
 Conway Center for Family Business, “America’s Economic Engine,” https://www.familybusinesscenter.com/resources/family-business-facts/
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