The Prudential Insurance Company of America
BUSEINESS STRATEGIES
Exit Strategies Using Life Insurance
For The Closely Held Business
[For use in CA, IL & TX must use LIFE INSURANCE SALES PRESENTATION]
[ Presented by:
[Joe Sample], [Designations per field stationery guidelines]
[Company Approved Title]
[Firm Name]
[The Prudential Insurance Company of America]
[1234 Main Street, Suite 1, Floor 10]
[Anywhere], [ST] [12345]
[in required states] [<ST> Insurance License Number <1234567890>]
[Phone] [123-123-1234] Fax [123-123-1245]
[joe.sample@prudential.com]]
© 2015 Prudential Financial, Inc. and its related entities
0190548-00007-00 Ed. 12/2015 Exp. 06/08/2017
Important Information
This material is designed to provide general information in regard to the subject matter covered. It
should be used with the understanding that it does not constitute legal, accounting, or tax advice.
Such services should be provided by your own professional advisors. Accordingly, information in
this document cannot be used for purposes of avoiding penalties under the Internal Revenue Code.
Life insurance is issued by The Prudential Insurance Company of America and its affiliates. All are
Prudential Financial companies located in Newark, NJ, and each is solely responsible for its own
financial condition and contractual obligations.
All guarantees and benefits of the insurance policy are backed by the claims-paying ability of the
issuing insurance company. Policy guarantees and benefits are not backed by the broker/dealer
and/or insurance agency selling the policy, nor by any of their affiliates, and none of them makes
any representations or guarantees regarding the claims-paying ability of the issuing insurance
company.
Securities and Insurance Products:
Not Insured by FDIC, NCUSIF, or Any Federal Government Agency.
May Lose Value. Not a Deposit of or Guaranteed by Any Bank,
Credit Union, Bank Affiliate, or Credit Union Affiliate.
Prudential, the Prudential logo, and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities.
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Business Continuation
The Process
• More than just exit strategies
• Incorporates all phases of the business life cycle
• Start-up: Creating and supporting
• Growth/Maintenance: Maximizing value
• Exit Planning: “Giving up control”
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Business Continuation Planning
The Need
• Small businesses (employ under 500 employees) comprise
over 99.7% of all employer firms in United States*
• Only 36% of small business owners have a business
continuation plan if they die. **
• Only 39% the business owners with a continuation plan have
life insurance in the plan***
* Statistics www.sba.gov/advo/research updated October 2015 FAQ
**Small
***Small
World Trends in the U.S. Small Business Market, LIMRA 2012
Businesses Owners 2009 Report, LIMRA International
LIMRA Statistics referenced on this slide (** & ***)are believed to be the most up to date available as of November 2015
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Before a Solution
Things your advisors need to know:
How the business is organized?
• “C” corporation
• Pass-through entity
• Partnership
• Limited Liability Company (LLC)
• S Corporation: Always an S corporation?
• Tax-exempt entity
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Before a Solution
Things your advisors need to know:
Who the owners are?
• What percentage does each own?
• What type of interest is owned (voting/nonvoting, limited
partnership/general partnership, etc.)?
• Are they also employees?
• Are they related to each other?
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Before a Solution
Things your advisors need to know:
General Numbers
• Salaries (including bonuses and “perks”)
• General value of the business
• Total number of employees
• Number of key employees
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Before a Solution
Things your advisors need to know:
Soft Facts
• Relationships
• Family members
• Business owners/employees
• Management style
• Special considerations
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Life Cycle Phases: Different Needs
Start-up Phase
• Focus: minimizing cost, maximizing protection
• Business and personal needs intertwined
• Key person insurance
• Property and Casualty*
• Disability Income*
• Family protection
*The availability of disability income insurance and property and casualty insurance varies by carrier and state.
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Life Cycle Phases: Different Needs
Growth/Maturity Phases
• Focus: attracting and retaining employees
• Benefits and retirement compensation
• Focus: business continuation and estate strategies
• Greater Cash Flow
• Qualified plans: 401(k) plans, 412(i) plans, etc.
• Medical insurance
• Nonqualified plans: Bonus plans, “True” NQDC, Welfare Benefit plans
• Maintain/monitor prior planning put in place
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Life Cycle Phases: Different Needs
Exit Strategies
• Dealing with the unexpected as well as the expected
• Are successors identified?
• Selling to a third party
• Selling/transferring to a family member
• Dealing with family wealth
• Minimizing estate and gift taxes
• Providing liquid funds for estate costs
• Dealing with the entrepreneur’s retirement needs
• Cash flow for the business
• Cash flow for the departing owner and new owner(s)
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Exit Strategies
Exit strategies include:
• A formal written buy-sell agreement
• A proper business valuation
• A funding mechanism
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The Buy-Sell Agreement
•Documents the legal obligation to sell/to buy and clearly identifies who,
when, and how much
•Creates a ready market for the business interests
•Protects the surviving business owners
•If properly drafted, helps to establish the value of the business for estate tax
purposes
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Establishing Value for Estate Tax Purposes
Three-Point Test
Buy-Sell Agreement
• Is entered into for bona fide business reasons,
• Provides that the arrangement is binding during life and death for a price determinable
from the agreement, and
• Is not a device for transferring property to members of the decedent’s family for less than
full and adequate consideration.
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Establishing Value for Estate Tax Purposes
Family Transactions
Add “Comparability Provisions” for Family Businesses
• Must be similar to fair bargain among unrelated parties
• Must follow the general business practices of unrelated
parties
• Must be similar in result to negotiated agreements between
unrelated parties
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Proper Business Valuation
Qualified Business Appraiser
• A person who, by education, training, and experience is qualified to perform an appraisal
of a business
• Has business valuation accreditations
• Follows authoritative guidelines
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Proper Business Valuation
Standards
Internal Revenue Service’s View: Fair Market Value (FMV)
• The amount a willing purchaser would pay a willing seller,
neither being under any compulsion to buy or sell and both
having reasonable knowledge of the relevant facts
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Business Valuation
Methods
Multiple Approaches but Two Basic Concepts
Liquidation Value
• Business ceases operations, sells off all of its assets and liabilities
• What would you get?
Valued as an “On-Going Concern”
• Based on earnings
• What would you pay for this money machine?
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Funding
The Favored Funding Mechanism: Life Insurance
Why?
• Building an investment reserve takes time.
• What if the owner dies too soon?
• Life insurance can provide the needed funds for death buyout from the date of
purchase.*
*Business owners should consult legal counsel to determine whether notice and consent under
IRC §101(j) is required before the policies are issued to receive tax-favored treatment. For
employer-owned life insurance policies issued after August 17, 2006, death proceeds will be
subject to income tax; however, where specific employee notice and consent requirements are
met and certain safe harbor exceptions apply, death proceeds can be received income taxfree. Life insurance proceeds are otherwise generally income tax-free under IRC §101(a).
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Life Insurance
Term vs. Perm
• Term insurance may be adequate when time period is short, owners are young, and
cost/cash flow is a consideration (i.e., start up years).
• Circumstances change: Consider conversion options and the use of permanent insurance
for later in the business cycle.
• For pass-through entities: Permanent insurance may be a better option to build “basis”
when future distributions are anticipated.
• Permanent policies, you pay premiums with the appropriate
premium payment schedule funded, can provide buyers with
the opportunity to accumulate cash values on a tax-deferred
basis.
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Life Insurance
Term vs. Perm
Provides needed cash to help meet obligation to purchase created by the buy-sell
agreement
• Death-time buyout: Death benefit proceeds
• Lifetime buyout: Cash value access through withdrawals and loans
Note: Withdrawals and loans reduce policy cash values and death benefits, may affect
any policy guarantees against lapse, and may have tax consequences.
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Buy-Sell Structures
Basic
• Stock Redemption Plan
• Entity Buyout (partnership/LLC)
• Cross Purchase Plan
• Wait-and-See Plan
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Stock Redemption Arrangement/Entity Buyout
Corporation
Agreement
Shareholder A
Agreement
Premium Proceeds
Insurance
Company
Shareholder B
• Agreement between business and each shareholder
• Business is owner, premium payer, and beneficiary of insurance on life of each
shareholder
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Stock Redemption
Advantages
• Simple: Only one policy per owner
• Business pays the premium: This may ease the cost burden for a younger owner or one
who has a minority interest
• Cash value: Treated as an asset on the corporation’s balance sheet
• Policy control: More likely that the policy proceeds will be used for buyout purposes
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Stock Redemption
Disadvantages
• Alternative minimum tax (AMT) may be triggered:
C corporations with average gross annual receipts that did not exceed $7.5 million for the
three previous years are exempt from AMT
• Family attribution rules for corporations: May cause the entity buyout to be taxed as a
dividend (i.e., ordinary income) rather than as a sale (i.e., capital gain)
• No basis step-up: Surviving owner’s interest in business increases, but his or her stock
basis remains the same (except for life insurance funded arrangements in pass-through
business entities)
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Stock Redemption
Disadvantages
• Voting power may be altered: Surviving owners’ interests are increased in proportion to
pre-death percentage
• Estate value increase: Proceeds received by the business may increase the value of the
decedent’s interest for estate tax purposes.
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Cross Purchase Arrangement
Shareholder A
Agreement
Premium
Shareholder B
Proceeds
Proceeds
Premium
Insurance
Company
• Agreement between shareholders
• Shareholder is the owner and beneficiary of insurance on
other shareholders
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Cross Purchase
Advantages
• Basis step-up equal to the price paid
• Family attribution rules do not apply
• No potential for AMT
• No estate value increase: Proceeds received by surviving owners do not increase the
value of the business
• Disproportionate purchase possible by surviving owners
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Cross Purchase
Disadvantages
• Discrepancies in age, health, and ownership interest may cause unbalanced allocation of
costs
• Who pays the premium? Will there be corporate reimbursement (i.e., a bonus plan)?
• Cash value of permanent policies owned at death on another owner are included in the
deceased owner’s estate
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Cross Purchase
Disadvantages
• Multiple owners require multiple policies
(n) x (n-1) = number of policies required
(where n is the number of owners)
• Policy Control: Are premiums being paid? Are policies being maintained? Will death
benefits be used to fund the buy-sell agreement?
• Transfer-for-Value issues tend to be more complex and could result in income taxation of
death benefit proceeds
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Cross Purchase
Multiple Policy Management
Solution? Trusteed Cross Purchase
• Trustee purchases one policy on each owner
• Trust is beneficiary of policy proceeds
• Trustee pays out death benefit proceeds according to the buy-sell agreement
• Issue: Does a transfer-for-value occur at the first death?
• Avoid the issue: Use the partnership exception to the transfer-for-value rule
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Wait-and-See Buy-Sell
What is it?
A hybrid agreement combining the entity and cross purchase approaches:
• The actual buyer is not identified until death
• Structured as a series of “Options to Buy”
• Business has 1st option to buy
• Surviving owners have the 2nd option to buy
• Business must buy if surviving owners do not exercise their option(s) to buy
• The order of the options is important if the transaction is to qualify for capital gain
treatment
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Wait-and-See Buy-Sell
Life Insurance
• Life insurance is generally structured as a cross purchase (i.e., each owner is the owner
and beneficiary of a life insurance policy on the other owners).
• Where the ultimate purchaser is the business, the surviving owners can help finance the
repurchase by lending the policy proceeds to the business or by making additional capital
contributions.
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After the Buy-Sell Arrangement Is In Place
The Process Is Not Over
Maintenance is Critical
• Updates to the buy-sell agreement
• Current appraisals to justify the business value
• Is funding adequate?
• Have circumstances changed?
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Questions?
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