A new concept in ‘cashing out’

Owning and managing a successful business in today’s ever-changing world can be an overwhelming task. You want to keep your books balanced and your creditors happy; you want to understand changes in tax law and how they could benefit (or hurt) your bottom line; you want to keep your existing customers happy while expanding into new markets; you want to attract, motivate, and retain quality employees. And wouldn’t it also be nice to relax and spend time with your family too? Did we leave anything out?

We did – and while it may not be number one on your “to do” list this week, given all of your other obligations, it may certainly be among the most important: You want to ensure that following a life changing “trigger” event – for example retirement, disability, or premature death - you have a ready buyer and a ready source of cash to purchase your share of the business.

Probably the most common method of “cashing out” of a business following one of these events is through a buy-sell agreement with your partner(s). There are various ways to structure the buy-sell agreement, including a stock redemption plan, funded with life insurance, where the business buys out your share following a “trigger” event; or a cross purchase plan, also funded with life insurance, where your partner(s) agree to buy out your share.

But there is also a new buy-sell concept that utilizes the benefits of tax-free life insurance and the legal protections of a partnership to ensure a smooth transition of a business to the remaining partner(s) following a trigger event.

Under this concept, each of the business partners - plus the business itself - enters into a general partnership agreement. Each partner purchases a life insurance policy on him or herself and then transfers ownership of the policy to the partnership as his/her capital contribution. For its part, the business transfers cash to the partnership as its contribution, and the partnership uses that cash to pay the premiums on the life insurance policies. In this manner, there are no income tax consequences to either the partners or the partnership.

Now “fast forward” several years. One of the partners decides to retire, becomes disabled or is ready to “cash out” of the business. At this time, the partnership would be terminated. Each partner would receive his or her insurance policy, including its cash value, income tax-free. An equal amount of cash value would be transferred from each partner’s policy to the business, representing liquidation of its capital account – in essence, the amount equal to the total premiums paid. The retiring partner would then keep his/her policy as payment of his/her share of the business, (if the cash value is insufficient to cover the total purchase price, the balance can be paid with an installment note, commercial loan, or other financing arrangement), while the remaining partners – and the business – would immediately enter into a new partnership agreement. The business would transfer its cash to the new partnership; the remaining partners would transfer their policies; and the partnership would essentially continue as before.

In the event a partner died unexpectedly, pretty much the same thing would occur. The partnership would be terminated; the business would receive a portion of the deceased’s death proceeds equal to its capital contribution (premiums paid); the balance of the death proceeds would be paid to the surviving partners or the deceased’s family, depending on how the partnership agreement was written; a new partnership would be established; and the process would repeat itself as before. Cash received by surviving partners may be used to purchase the deceased’s interest in the primary business.

The end result: Each partner has the peace of mind that comes with knowing that, in the event he or she dies, becomes disabled, or decides to retire, there will be a ready buyer, and ready cash, to ensure a smooth transition. A retiring (or disabled) partner knows that, even though outstanding loans will reduce the face amount and cash value of the policy, he/she can take income tax-free loans from his or her policy to meet living expenses or supplement retirement income. And, in the event of death, the deceased partner’s family knows it will be compensated for the deceased’s share of the business; the business will have adequate capital to continue operating for the benefit of the other partners and employees; and it will all happen in a tax-efficient manner.

Sure – as a successful business owner, you have a lot to do every day. But don’t put off planning for what may be your most important concern – making sure the business into which you’ve invested your money, time, and effort, is there to help you, and your family, when you need it the most.

This information is for educational purposes and should not be considered specific financial, tax or legal advice. Always consult with a qualified advisor regarding your individual circumstances.

Winfield C. Greenwood, RFC® is the owner/founder of Redstone Financial Group, LLC, an independent financial services firm based in Las Vegas. He shares his expertise on business and personal financial planning with the RJ every week. Contact him at (702) 475-6363,wgreenwood@redstonefg.com, or connect via Facebook or Twitter.