When a business owner dies, a multitude of potential issues can occur:
The surviving owners want to (1) either secure or keep control of the business without interference from the decedent’s heirs; (2) quickly transfer of the decedent’s interest at a reasonable price; and (3) maintain the allegiance and backing of employees, customers, and creditors during and after the transition in ownership.
The decedent’s heirs want (1) continuing financial security after the loss of the decedent’s salary and benefits; (2) either preservation of the business interest or a judicious sale at an appealing price; and(3) quick payment of the decedent’s estate (including proper tax valuation of the business interest, if they plan to sell it).
Disputes and possibly even litigation might arise between the decedent’s heirs and the surviving owners. Postponements in the transition to replacement ownership and in establishing the decedent’s estate may be inevitable. Loss of customers, employees, or lack of creditor support could damage the business—and perhaps even force its closing.
A formal, written buy-sell agreement among the business owners is necessary to ensure an organized and positive transition in business ownership following an owner’s death. The contract sets a reasonable price for the business interest and terms of sale that are acceptable to all parties.
The value established in a buy-sell agreement usually establishes the amount for estate tax purposes, which helps to avoid estate settlement delays and IRS challenges. If the owners are related, they should secure a professional appraisal of the business. Check with your legal counsel for advice on this subject. An existing buy-sell agreement encourages confidence in the ongoing vitality of the business in the eyes of customers, creditors and employees.
The Net Result
A properly designed and funded buy-sell agreement satisfies the valid concerns of all parties involved by assuring business continuation that benefits sellers, buyers, employees, customers, and suppliers. When a business owner dies, the consequences depend to a great extent on how well the business prepared for such an event.
What the Surviving Owners Want
The surviving owners typically look to retain total control of the business without interference from the decedent’s heirs. They may also hope the heirs promptly sell them the decedent’s interest at a fair price, while striving to retain the loyalty and support of employees, customers, and creditors during and after the change in ownership.
Management Bonus Plan
A management bonus arrangement, also sometimes referred to as a “Section 162 Bonus Plan” is a benefit arrangement in which an employer pays bonus compensation to selected employees in the form of premium payments on the executives’ personally owned life insurance policies. It is most easily described as employer-funded personal life insurance.
The management bonus arrangement may be of special interest to employers who desire to reward key employees with supplemental benefits, without extending these additional benefits to all full-time employees as would usually be required under a qualified plan. It also may be of interest to employers who have qualified plans in place, but feel they need another benefit with which they can reward certain key executives.
Description and Approach
Documentation Required: If there are no restrictions placed on the executive bonus arrangement, the only documentation needed is a corporate resolution adopted by the employer’s board of directors. The resolution should establish the purpose for the bonus (for example, to help recruit, retain, and reward key executives). While it is not required, it may nevertheless be advisable for an attorney to formally document an agreement in writing between the employer and the executive that clearly defines the terms of the bonus arrangement.
Typically, the executive both applies for and owns the permanent life insurance policy. As the owner of the policy, the executive has the right to name the beneficiaries of the policy’s death benefit. However, the executive should not name the employer as beneficiary of the life insurance policy; otherwise the bonus would not be income tax deductible to the employer.
The employer may then either pay the premiums on the life insurance policy directly to the life insurance company or bonus the premiums to the executive, and the executive in turn writes the check to the insurance company. Sometimes, the employer will agree to pay an additional bonus amount to help the executive pay the income taxes on the bonus.
This plan is generally considered as a “double incentive.” In later years, the cash value of the permanent life insurance policy can potentially be accessed via policy loans or withdrawals to pay the additional income tax on the bonus amount, or for other needs. It is a fact that loans and withdrawals will decrease the cash surrender value and death benefit.
Limited Management Bonus
If the employer desires to control when distributions can be made to the executive, a special endorsement may be placed on the life insurance policy which would require the employer’s consent for the executive to: borrow cash values, surrender the policy, assign or pledge the policy as collateral for a loan, or change ownership of the policy. This endorsement would not give the employer any rights in the life insurance policy, other than the limited ability to participate in decisions that would affect how the policy is used during the time specified by the restriction. The executive would still be able to change the beneficiary.
The agreement between the parties would typically establish when the restrictions were scheduled to expire. Triggering events often include: the executive’s retirement or disability, the attainment of a designated age, or when the employer discretionarily releases the restriction. Once employment is terminated or once the restriction period otherwise expires, a written statement from the employer to the insurance company is required in order to remove the endorsement from the policy.
The cash bonus or premiums paid by the employer will be reported as additional compensation on the executive’s W-2 in the year in which the bonus is received. The compensation bonus is deductible by the employer in that same year, provided the executive’s total compensation is a reasonable amount.
Again, it is important to document the executive bonus arrangement via a corporate resolution in order to help establish the expense as a business expense of the company, thus helping preserve the tax deduction. At the executive’s death, the life insurance death benefit proceeds are generally received by the executive’s designated beneficiaries free of federal income taxes.
If estate taxes are a concern for the executive, he or she may wish to establish an irrevocable life insurance trust (ILIT) to own the life insurance policy. However, if the policy is owned by an ILIT, gift tax issues will need to be addressed.