There are some estate planning situations that are out of the ordinary, but there are many tools in the estate planning toolkit, so there is always a solution. One of these scenarios is succession planning for small business partners. We will explain this dynamic through the utilization of a simple example.
Let’s say that you and one partner open up a restaurant, and it becomes very successful. You pour everything that you have into the business over the years, and your partner does the same. At some point, you recognize the fact that the business is your most valuable possession.
You have two children, and neither one of them wants to help run the restaurant. When you are planning your estate, how do you account for the business? If you leave your interest in the business to your children, what are they going to do with it? They could sell it, but the buyer may not be someone that your partner would want to work with, and you want to be fair.
This type of situation is typically addressed through the utilization of a buy-sell agreement called the cross purchase plan. The way that it works is you get together with your partner to determine the value of each share in the business. After you come to an agreement, you and your partner purchase life insurance policies on one another. The payouts would be equal to the value of a share in the business.
For the purposes of this example, we will assume that you predecease your business partner. After your passing, the insurance company will transfer the proceeds to your partner. The money will be used to purchase your share of the business from your family. They will have liquidity to share, and your partner will be able to run the business as usual.
There is another type of buy-sell agreement called a redemption agreement. This works the same way as the cross purchase plan, but the insurance policies are not purchased by the partners. The business itself takes out insurance policies, so this can be useful when there are multiple shareholders.
A third type of buy-sell agreement is a hybrid agreement that contains elements of the cross purchase plan and the redemption agreement.
It should be noted that this succession planning strategy does not necessarily have to be tied to insurance and the passing of a business co-owner. An agreement like this can allow partners or major stakeholders to retire. There would be no insurance involved, but the business entity or business partners can agree to purchase the share that is owned by a departing partner at an agreed-upon price.
There is another way that insurance can be used by small business owners that have estate planning concerns. To explain by way of another example, you own a restaurant, and your son has helped you run the business throughout his adult life. You want to leave the family business to your son after you are gone, and he would like to own the restaurant when the time comes.
Your daughter is you only other child, and she has never had any desire to be involved in the family business. You love each of your children equally, and you want them to get equal inheritances, but the restaurant is your most valuable piece of property. To balance inheritances, you could take out a life insurance policy that pays your daughter a benefit that is equal to the value of the restaurant that you will be leaving to your son.
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