Too often entrepreneurs spend years building a business and come to an agreement with a partner or family member over succession, but fail to make plans to finance the succession. That is where life insurance plays a role. By insuring the head of a small business corporation or each senior partner, a small business can weather the death of a partner and ensure succession follows the course intended by the entrepreneur.
Small business owners usually need permanent or universal insurance, rather than term insurance. Permanent insurance is necessary because it lasts for your lifetime – a term policy that ends at 75 is no good if a 75-year-old still has all his capital tied up in the business. Succession is a big issue for small companies and you need advice from someone who understands the role of life insurance. Your best choice of advisor is a Chartered Life Underwriter. See Choosing an insurance advisor
Capital gains exemption on small business shares
The planning process must include preparation for paying of estate taxes on the business. When a small business owner dies, an assessment is made on the value of the business. If it qualifies as a closely held corporation, there is no capital gains tax on the first $750,000 of value in the business. The tax-free amount may be offset by any capital business losses the owner declared in his or her lifetime.
Insurance can be used to cover capital gains tax on the value of the business over and above $750,000. Depending on the structure of your succession agreement, you might use life insurance to allow a partner to buy out your share, an heir to take over or to provide an inheritance to a child who is not involved in the business.
Paying estate taxes
Suppose a sole proprietor has built a business valued at more than $1 million. He wants his son to take over, but is worried about estate taxes. When he dies, his estate will owe taxes on the capital gain in the business. There may be very little to go to his wife, because of the huge tax bill and his son may have to take out a loan he cannot afford.
The solution is a life policy on the sole proprietor sufficient to pay the taxes. The company itself takes out the policy and pays the premiums. When he dies, the death benefit goes to a capital dividend account, minus the amount spent in premiums. That benefit can be used to pay the estate taxes and his son can take over the business. The son benefits from the new adjusted value of the business and can keep on building.
Working with a partner
A similar arrangement can be made between partners. Many partners sign an agreement that they will buy one another out, but if one partner dies unexpectedly, there is no guarantee the other partner will be able to get a bank loan to cover the cost of half the business they have built together. The deceased’s family finds their wealth is tied up in the business and they face both estate taxes and a partner who cannot live up to the agreement.
If the partners buy cross-owned insurance – making each other or the company the beneficiary when they die, the money will be available to buy out the other partner. The widow or widower must sell to the partner and the money is there to cover the cost.
Key person insurance
Small companies are often dependent on the expertise of a few top people. If a major sales rep or a top researcher dies, it can hurt business prospects. Some entrepreneurs take out key person insurance to protect against the loss of their best employee. If that key person dies before retirement, the business will use the money to go out and recruit someone of equal experience, at a premium salary covered by the death benefit.
What if the entrepreneur wants to retire, and turn her business over to a promising heir? How can she turn her equity in the company into capital to fund her own retirement? Many small companies opt to continue paying a salary to the retired founder of the business. Or an heir can slowly buy her shares, supplying a regular income. However, if she has a universal life insurance plan, now may be a good time to take the value out of that contract to fund her retirement.
Mom and Pop Business
The smallest businesses may not be worried about paying estate taxes so much as leaving an equal legacy for each of their children when they cannot all be involved in the business. Milton and Betty Lau have built a Mom and Pop business valued at $1 million. They want to leave it in the capable hands of their daughter, Winnie, who has been a long-time participant in the business. But there is little outside the business to leave to their son, Percy, who chose a separate career.
At their deaths, both Milton and Betty can claim the $750,000 capital gains exemption. Their wills can specify that Winnie inherit the business. But both or either can take out insurance on themselves to ensure there is an inheritance for Percy. The policies would list Percy as beneficiary, and the money goes to him tax-free. Your advisor can recommend the amount of the insurance benefit – it is not necessary to equal the full $1 million value of the business because Winnie is inheriting something that requires a lifetime of hard work.
This article was written by Advocis®, The Institute for Advanced Financial Education™ (The Institute™), CLU®, CHS™, CH.F.C.® and APA® are trademarks of The Financial Advisors Association of Canada (TFAAC).
To find out more information on how you can set up these insurances for yourself or your business, contact Lynn Cain CFP for more information. You will be really glad you did!
Lynn Cain, CFP
Lifecycle Planning for Lifestyle Protection.