There are many factors that influence the success or failure of a business. The costs of doing business, including manufacturing, distribution, and marketing of products or services are some of these financial factors. Overhead costs, such as rents, employee salaries, and utilities can also eat into the profitability of a given company.
If the company’s owner and/or key employees should die unexpectedly or become disabled and cannot work, overhead costs continue to pile up. Business operating expenses may be protected using a specialized form of insurance that helps to cover overhead costs in cases of disability or loss of the owner. These policies provide money when it is needed, and premiums are generally considered tax-deductible business expenses. Business overhead expense insurance policies protect a company from forced liquidation, helping to preserve the hard work and market share the company has developed over its time in operation. In this guide, we will introduce business overhead protection plans and discuss options available to business owners.
Before delving into business overhead protection plans, it is useful to take a look at statistics associated with disability. The odds of a business owner becoming disabled for 90 days or longer before reaching the age of 65 is surprisingly high. If there is more than one owner, the odds increase dramatically. For example, a single business owner aged 30 has a 54% chance of becoming disabled for 90 days or longer. A business with 5 owners, all around the age of 30, shows a 98% chance of one of the owners becoming disabled.
The odds drop with age, but the numbers are still significant. Building on the example above, a single owner aged 55 has a 25% chance of a 90-day or longer disability. With 5 owners the same age, there is a 76% chance one of those owners will become disabled.
The length of disability is high as well. For disabilities lasting longer than 90 days, the average duration of the disability is approximately 2.2 years for a business owner aged 30. For a 55-year-old owner, the average duration of disability is right at 2.5 years. These numbers have serious implications for business operations.
How Will Business Overhead Expenses Be Paid?
In the case of a long-term disability or the death of one or more primary business owners, many companies struggle to pay for the day-to-day expenses associated with keeping the business running. Day-to-day expenses, or business overhead, consists of costs like:
These costs continue to stack up, even if the owner were to become disabled and cannot work. Of course, these expenses must continue to be paid, regardless of the circumstances. The business and its leaders have important decisions to make regarding the future of the business and its continued operation, especially when it comes to a long-term disability.
Alternatives in Cases of Owner Disability
When a business owner becomes disabled for a length of time, three potential scenarios as to the future of the business arise. Each scenario has its own advantages and disadvantages. The first is to sell the business, which can serve as a relatively viable alternative only if the current owner wishes to sell and can identify an interested party with the funds needed to complete the sale on favorable terms.
A business may liquidate – and, in fact, financial analysts refer to this scenario as a forced liquidation. The business may be disposed of rather quickly in this scenario, but the terms may not be favorable. The business may sell for a fraction of its true value, especially when contrasted to the value of the business if it was still operating with an eye to the future. Owners and family members may also rush into agreements before carefully evaluating the business operation and its intrinsic value.
Finally, remaining owners and family members may wish to maintain the business. This has advantages when the owner’s disability is considered to be a short-term situation; he or she can return when recovery is complete. Without a viable source of income, however, operating expenses pile up and the remaining alternative may end in a company sale or forced liquidation.
Funding Sources for Overhead Costs
Business expenses continue to accrue, even if a business owner is disabled. There are several potential sources of income to cover these expenses. As with the scenarios discussed above, there are strengths and weaknesses to each of these income sources – and most stand out as insufficiently reliable to ensure business continuity. Funding sources include:
Business and Personal Savings – smart business owners know that they need to create a savings plan to hedge against future circumstances. However, saving revenues can be a lengthy process. If a business owner were to set aside 10% of revenues each year, it may take 10 years or more to save one year’s worth of business revenue. Owners facing a long-term disability may consider dipping into personal savings to cover overhead costs, but this can create further financial instability and hamper the ability to pay for personally-related expenses.
Loans – a loan is an option, but finding a lender willing to fund a loan while the owner is disabled is difficult, at best.
Asset Liquidation – a business may opt to sell a portion of its assets, including equipment, inventory, properties, and vehicles. Again, this option is considered a forced or emergency liquidation. Selling assets can interfere with the continued operation, and it also lowers the value of the overall business.
Personal Disability Income – like personal savings, a business owner may attempt to cover operating expenses with this income source. However, the owner and his or her family’s expenses will still need to be covered, and using disability income for business means that it may create significant financial hurdles for the family.
There is only one reliable source of funds to pay for business overhead expenses. Referred to as business overhead expense protection, this funding source has many advantages over the alternatives. In our next article, we will go over the highlights of this source, helping business owners to make smart decisions about the future of their operations.
Family-owned businesses are unique in the world of commerce. These businesses may have started simple, then grown over the years to become local, regional, or even national powerhouses. Family businesses may be passed down from generation to generation.
When a business owner dies or becomes disabled and is no longer able to handle business operations, family members are often confronted with difficult decisions. This is especially true when there are no heirs to pass a business down to, or they are uninterested in continuing operations. Business liquidation may become the only option available. In this guide, we will discuss the concept of business liquidation insurance, when it is appropriate, and how to make smart decisions concerning the final disposition of a business interest.
Liquidating a Business: Tough Decisions Ahead
As mentioned earlier, family-owned businesses are often multi-generational affairs. The business is handed down to subsequent generations. What if, however, the business owner dies and doesn’t have a trusted family member to pass the company down to? What if surviving heirs are not interested in carrying on business operations? What if the owner becomes disabled and cannot carry on the duties he or she needs to complete to keep the business running? What if no other outside buyer is interested in purchasing the company from surviving heirs? These are difficult questions, and raise the possibility of very tough decisions. In these cases, a business liquidation may be called for.
Let’s dig a little deeper and explore two scenarios that may make a liquidation the only outcome, particularly when the current owner dies or becomes disabled:
Faced with the sudden death or disability of the current business owner, there are two potential scenarios of a business liquidation: forced or planned.
A Forced Liquidation
Without a successor plan in place, if a business owner were to die or become disabled in some way as to not be able to continue business operations, a forced business liquidation can be the only recourse. This is often the case when surviving heirs inherit business interests and are disinteresting in continuing. In a forced liquidation, public knowledge of the potential liquidation of the business can create incredible pressure on those who are left with the operation. This pressure can lead to unpleasant results, including:
The major takeaway of a forced liquidation is that in this situation, the value of the business can be greatly reduced. The value of a business is always unpredictable, but a forced liquidation further complicates the picture.
A Planned Liquidation
Smart business owners know that nothing lasts forever. For business owners without heirs, or with family members or business partners that may not wish to continue the business operation after the owner dies or becomes disabled, strategic planning for future liquidation is a logical move.
There are two major components to consider when planning for a future liquidation: Authority and Time.
Authority: while a business owner is still alive or able to conduct business without disability, he or she generally has the authority needed to sell the business or its assets. This authority includes who the business can be sold to, how much to sell the business or its assets for, and when the sale might take place. For the purposes of a liquidation, it is critical that the executor of the owner’s wishes have the same decision-making authority. This authority is often granted in a well-drafted will.
In the will, specific details must be included. These give the executor the power to decide how and to whom the business is sold, how much to sell the business and/or its assets, and what form of payment will be accepted in the sale. The will should also include provisions for the timing of the sale; executors should be given the power to decide to continue operating the business until it can be liquidated in an advantageous manner. Finally, personal liability provisions included in the will should protect the executor from any personal liability, covering reasonable actions taken in the continued operation and eventual sale of the business and its assets.
Time: a disabled owner or the executor of the owner’s wishes after death still needs adequate time to make decisions about the future of the business and its liquidation. Here, there are two scenarios that must be considered in the planning stage. The first scenario is the owner’s death. In that event, the deceased owner’s estate must have sufficient funds available to buy the time needed to liquidate the business assets in a manner that is advantageous to the surviving family’s financial interests. Funds may be needed to pay estate settlement costs, estate taxes, and to provide an income for surviving family members. Without sufficient funding for these costs set aside, the executor may be forced to move too quickly in liquidating the business, potentially losing significant value, not to mention market leverage.
In the second scenario, the owner becomes disabled. Here again, adequate liquidity in finances makes it possible for the owner to sell the property at a fair market value rather than being forced to move too quickly. Income for expenses and for family needs buys the time necessary to liquidate the business assets in an orderly manner.
Business Liquidation Insurance
In our next article – part two of this series — we will discuss the option of business liquidation insurance and how it can protect the value of business assets in the case of death or disability of the owner. This generally takes the form of life insurance to provide funding needed for orderly and fair liquidation of the business interests.
Passing down a successful business from generation to generation is the goal of many business owners, as discussed in our previous piece.
With advanced planning involving an insured Section 303 stock redemption plan, many obstacles that occur at the owner’s death can be avoided. Some obstacles that a Section 303 helps to avoid are:
Facts, Features, and Funding a Section 303
Funding a corporate Section 303 stock redemption plan can occur in three different ways:
Of the three different ways, the insured method is the only one that guarantees that the cash needed to redeem the stock at the owner’s death will be available.
The features of a Section 303 stock redemption plan can help a business owner accomplish the following:
Some important facts to remember when constructing a Section 303 stock redemption plan include:
Taking all of the above into consideration, any current and future estate tax provisions should be taken planned for when the retention of shares occurs in a closely-held corporation at a shareholder’s death.
Estate Planning Considerations
The federal estate tax is a progressive tax which increases from 18% up to as much as 40% based on the taxable value of an estate. This tax is essentially a transfer tax levied on the privilege of transferring property at the death of the owner.
If a property is transferred while the owner is still living, a federal gift tax is imposed on the transfer. The tax is not a tax on the asset itself, but rather on the right to transfer the asset. However, the determined amount of tax payable is measured by the value of the transferred asset.
Next, once the federal estate or gift tax is determined, the amount is reduced by a gift and estate tax unified credit. For taxable estates with a value less than or equal to the unified credit, federal estate taxes will not be due. A cumulative lifetime taxable gift also falls under the same rules, but the gift amount is added back to the value of the owner’s estate to determine federal estate taxes.
In 2018, the unified credit equivalent, as adjusted for inflation, is $11,200,000. This means that an individual may transfer, as a gift or after death, an amount over $11,000,000 without incurring any tax liability.
Additionally, a spouse may also take advantage of any unused portion of the estate tax unified credit ($11,200,000), not used by the other spouse. With careful estate planning, a married couple can essentially shield over $22 million from the federal estate and gift tax.
The estate tax deferral allows the payment of this estate tax that is attributable to the value of the closely-held business included in the estate to be deferred for a time period of up to five years.
Generation-skipping Transfer Tax
The generation-skipping transfer tax (GSTT) involves skipping a generation when transferring property. Since the federal government collects taxes on property transfers from one generation to the next immediate generation, such as father to son, the GSTT allows an estate owner to skip the children and transfer property to a family member who is two or more generations removed, such as grandfather to grandson. By doing this, the government is deprived of any estate taxes that might have been collected on the property by children of the property owner.
A generation-skipping transfer more than the available exemptions is subject to the maximum federal estate and gift tax rate of 40% for 2018. The GSTT is an additional tax due and payable by the estate, transferor, or the trustee of the trust set up in a generation-skipping transfer.
There are many different legal ways to avoid paying the government more than it is trying to take. A Section 303 stock redemption plan funded by life insurance is one very advantageous way to set up a series of events at the owner’s death that will leave the surviving family members and the family business in secure financial shape.
As with any complex business and estate plan, talk with a qualified financial advisor. Plan with flexibility in order to adjust to an uncertain tax future. Protect your family and your legacy today by talking with a financial advisor.
Business owners who intend to leave their successful business to one or more children should consider an insured Section 303 stock redemption plan for estate tax purposes.
No one wants to give the government more of their hard-earned money than legally obligated. If planned correctly, an owner of a closely held corporation can reduce the amount of taxes paid by the estate once the owner is deceased. For owners of a closely held corporation, several questions arise:
The Answer: Section 303 Stock Redemption Plan
One solution to many of these questions is a Section 303 stock redemption plan. Surprisingly, Internal Revenue Code (IRC) Section 303 was enacted over 60 years ago in 1954. Congress wanted to make it easier for small business owners to pass along their business from generation to generation. Today, Section 303 can be used for owners of closely held corporations (businesses in which there are few stockholders and a majority of the stock is held by the owner) to sell back the stock to the corporation and provide the surviving family members with enough cash to pay for expenses that result from the owner’s death.
If this code were not in place, many of the distributions in redemption of a deceased shareholder’s stock would be treated as a dividend instead of a capital transaction and would be subject to ordinary income tax rates. However, with Section 303, the qualifying redemption of stock is only taxable to the extent that the redemption exceeds the estate’s basis.
For example, a $2 million distribution, without the protection of Section 303, would be subject to around a $700,000 income tax hit. However, with a Section 303 in place, there would likely be no tax due. This is good news for survivors who need cash to pay death costs such as funeral expenses, estate taxes, and administrative costs.
In order for an amount to qualify for favorable tax treatment granted by Section 303 reaches a limit at the sum of:
For amounts under the $5 million federal tax exemption limit, Section 303 can still be used to offset state inheritance taxes, estate taxes, funeral expenses, and administrative expenses.
In order to qualify for Section 303 treatment, the decedent’s stock included in the gross estate must be more than 35% of the adjusted gross value of the estate. The 35% of stock may be combined from up to 3 different corporate stocks. However, the adjusted gross value of an estate is not known until death occurs. Therefore, advanced planning is highly recommended.
The beneficiary or estate who receives the redeemed stock is not directly liable for the estate taxes, administrative costs, and funeral expenses. However, in order to adhere to Section 303 rules, the recipient of the interest from the redeemed stock is liable and must be directly reduce the amount by paying taxes or expenses, such as estate taxes, administrative costs, and funeral expenses.
The Mechanics of an Insured Section 303 Stock Redemption Plan
An economical and efficient method of providing cash to the family and heirs is with life insurance. This allows settlement of a deceased owner’s estate, while allowing the family to retain controlling interest in the family business.
Using life insurance, owned by the corporation, allows the business to be named as the beneficiary of the policy. The corporation is then responsible for payment of the nondeductible insurance premiums on the owner’s life. The amount is an approximation of the required amount necessary to make the partial stock redemption. The owner and corporation enter into a Section 303 redemption agreement where the corporation agrees, at the owner’s death, to redeem a portion of the owner’s stock that is equal in value to the total estate taxes, funeral costs, and administration expenses. This stock is given to the executor of the estate and is then sold back to the corporation.
At the death of the owner, the corporation receives an income tax-free death benefit from the insurance company. The proceeds from the life insurance policy are sued to buy back a particular portion of the owner’s stock to pay estate taxes, funeral expenses, and administrate costs. Since this amount is not known until the date of death, the amount of life insurance received by the corporation may exceed these costs. If so, the remaining amount is considered as tax-free to the corporation. Then, the remaining stock is distributed to the family which continues controlling interest in the corporation.
There are many different routes that a business owner can take to protect his or her family after their death. IRC Section 303 redemption is just one of them. However, for business owners who determine that upon their death a shortage of cash may harm the business or the family, an insured IRC Section 303 redemption can be a lifesaver.
Even if, at death, the cash is not needed by the estate or the corporation, a Section 303 redemption is a tax-efficient means of removing cash from the business that would have been taxed as a dividend once it was distributed. Since there are no tracing requirements for funds received in a Section 303 redemption, having this plan in place can automatically save thousands of dollars in taxes.
Since an insured Section 303 stock redemption plan is often an involved and complicated endeavor, discussions with a highly qualified financial advisor is needed. Preplanning for the unexpected is definitely a way to protect your business, family, and legacy. Contact a financial advisor today to discuss all of the ways you can use life insurance to protect your most precious assets.
For business owners, leaving a legacy behind for their children is often a driving factor. Leaving that legacy to chance is not.
If the owner of a business passes away, often, the family will have to borrow the cash needed to pay for funeral expenses, taxes on the estate, and ordinary income taxation of stock assets. For those whose main goal is to help avoid these expenses on the family, a Section 303 stock redemption arrangement is a viable option.
For many family-owned businesses, if a son or daughter is willing and able to assume responsibility for operating and owning the business, if steps are not taken beforehand, the death of the business owner may cause insurmountable financial obstacles for the family members who are left to continue to business.
Obstacles to Successful Family Retention
A company that has a limited number of shareholders whose stock is traded publically on occasions is known as a closely held corporation. For these types of businesses, the death of one of the primary shareholders can place a financial burden on, not only the business, but the family as well. Establishing a Section 303 stock redemption arrangement funded with life insurance may be the perfect solution for the shareholder, if:
Some financial obstacles for a closely-held corporation at the death of the owner, include:
Advance planning will help to overcome any of these financial obstacles, leaving the family the ability and assurance of a successful family retention of all business expenses. Without it, there may be no choice but to sell or liquidate the business.
A Potential Solution
One possible solution to an estate liquidity problem is for the corporation to purchase a certain portion of the deceased owner’s stock. This allows the family the much-needed cash to pay an estate settlement bill, while still retaining the important controlling interest in the business.
This would be the perfect solution, except for taxes. When a corporation purchases its own stock, the transaction is treated as dividend income. This means that ordinary income tax would have to be paid by the heirs on all proceeds of the stock redemption. However, there is an exception to this rule that allows a corporation to redeem its own stock with favorable tax conditions.
Section 303 of the Internal Revenue Code (IRC) states that a corporation may purchase enough of its stock from a deceased owner’s estate to pay any estate taxes, funeral costs, and estate administration expenses. In addition, any gain from a Section 303 stock redemption is taxable as a capital gain. However, since the stock’s value takes a step-up in basis to its fair market value on the date of the owner’s death, the gain realized is usually little to none.
Section 303 and Life Insurance
The IRC allows corporate stock from a deceased owners estate to be redeemed. This transaction is now considered a capital transaction when these proceeds are used to pay estate taxes, state death taxes, and any administrative expenses. Otherwise, the transaction would be considered ordinary income and fall under regular income tax guidelines.
Life insurance allows the corporation to buy and own the life insurance on any key owners or shareholders. In a Section 303 stock redemption agreement, life insurance can help facilitate the arrangement by giving the corporation the liquidity needed to purchase the owner or shareholders company stock after their death. This allows the business to be kept in the family and any liquidity issues at the uncertain time of death. Often, this is the exact time when liquid assets are needed.
Potential Benefits of Using Life Insurance
The benefits of using life insurance in a Section 303 stock redemption agreement allow for:
Death is an uncertain time no matter the circumstances. Adding life insurance can help ease the burden of paying for funeral expenses, taxes, and other unforeseen costs that may arise. In addition, if the family depends on the deceased members’ income, planning ahead elevates the need for drastic changes in living situations, routine, or even future expenses, such as college.
As with any complex financial matter, discussing your concerns with a highly qualified financial advisor will put you, your family, and your business on a path to stability in the event of death. Planning also allows a company to invest in the future and to build a strong, solid presence in the event of an owner’s death.
Americans work hard to achieve the financial security and lifestyles they desire. As we work, many of us are able to use our earning power to purchase homes, save for retirement, do some traveling, and engage in hobbies and other lifestyle activities.
What happens if you were to become seriously ill? How can you protect your financial assets and your lifestyle if faced with a critical illness that impacts your earning and how you live your life? In this series of blog posts, we’ll discuss ways to protect your assets by laying the groundwork and preparing for whatever the future holds. There are several steps one can take to ensure continuity of lifestyle, and our blog series will cover some of the best ways to keep financial assets where they belong: in your care.
What is Earning Power?Before delving into asset protection during a critical illness, it is important to discuss the concept of earning power. In simple terms, this means your ability to earn an income. It is the most valuable of one’s assets, and everything we do is dependent on earning power during our working years.
Earning power consists of four income sources:
What are Critical Illnesses?When we use the term “critical illness”, we are not talking about colds and flus or other illnesses that may cause you to miss a few days of work. Here, critical illnesses are life-threatening health complications like heart attacks, strokes, cancer, and pulmonary diseases. Some good news is that many of these illnesses are survivable, thanks to advances in medical care and treatment, the fact remains that any of these serious health issues can greatly impact one’s finances and ability to earn an income.
Let’s dig deeper into several of the major critical illnesses and discuss some statistics of these life-altering situations:
Heart Disease – over 85 million Americans are currently living with some form of heart or cardiovascular diseases. It is one of the leading causes of death in the United States; such a disease strikes someone in the U.S. every 42 seconds on average.
Cancer – U.S men have about a 50% chance of developing some form of cancer during their lifetimes. For U.S. women, there is about a 33% chance of developing cancer. In 2016 alone, over 1.5 million new cancer cases were reported. While cancer survivorship has increased over the past decade, it remains a very serious illness that can interfere with one’s life.
Strokes – a stroke occurs, on average, every 40 seconds in the United States. Strokes are the leading cause of long-term disability in the American workforce; many will face long periods of disability, while others will become permanently disabled as a result of a stroke.
When considering the prospect of critical illnesses during your lifetime, it is important to think about several questions:
Heart disease ranks as the #1 killer in the U.S., and strokes are not far behind at #5. This is true for both men and women. As recently as 2013, over 800,000 people lost their lives to heart disease in the U.S.
In addition, heart disease and strokes account for chilling frequency of long-term disability. If a person should have a heart attack or stroke, he or she may not be able to work for long periods of time, if ever again. Of course, this means that finances must be in place in order to pay for healthcare costs and for household expenses for the duration of the disability.
Next Up: Funding Sources to Help Financially Survive a Critical IllnessWe’ve gotten the definitions and statistics out of the way – these are both very chilling areas to be aware of. In our next blog post in this series, we will begin to discuss some of the funding sources, particularly insurance, that may be able to help pay for the direct and indirect costs of critical illnesses. Stay tuned for more.
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A successful business begins with talented management. However, that same business can suffer tremendously when a key employee or an owner dies or becomes disabled. The financial impact that a death or disability of an owner can affect not only the ability of the business to survive, but also the overall value of the business.
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There are five questions a business owner should ask when thinking about protecting a business:
When evaluating the impact on a business at the death or disability of an owner or key employee, business protection planning can assist. Since the death or disability of an owner or key employee can have a serious impact on future profitability, having a plan in place may be the key to the continuation of the business. This change may affect a great number of people, depending on how many employees will be affected by the death or disability.
If business loans have to be repaid, the personal assets of a small business may have to be used if there are not liquid funds available. Without any liquid funds available to pay business overhead expenses, if an owner becomes disabled and is unable to work, there may be no choice but to sell or liquidate the business, even if a short-term recovery is likely.
Key Employee Indemnification
The most valuable assets a business has are not the building and equipment, but rather they key employees who make significant contributions to the success of the business. The unexpected death of one of these key employees can have a serious impact on business profitability.
Funds may be needed to supplement the business for the loss of a key employee for several reasons, including:
Many small business owners frequently have to personally guarantee a commercial with their own personal property. Therefore, the owner’s personal assets could be at steak if the owner dies with an outstanding business loan. Even if a personal guarantee is not required, many creditors require assurance that a loan will be repaid if the owner dies suddenly and unexpectedly.
Advance planning can help to minimize the negative financial impact of an owner’s death when there are outstanding business debts. The business, the deceased owner’s family, and any other owners may be negatively affected financially.
Some issues to consider when an objective is to guarantee repayment of business loans at an owner’s unexpected death:
When a business owner becomes hurt or sick and is unable to work, the day-to-day costs of operating a business do not stop. Rent, salaries, telephone, utilities, and other expenses are a few examples of ongoing costs that must be paid for the business to continue without interruption.
When an owner suffers a disability for a period of time, there are three alternatives with very different outcomes:
When planning to keep the business up and running during a short-term disability period, there are some questions that a business owner should ask: