CREATED EXCLUSIVELY FOR FINANCIAL PROFESSIONALS NOT FOR CONSUMER USE. [PRESENTED BY:] Joe Sample, [Designations per field stationery guidelines] [Company

CREATED EXCLUSIVELY FOR FINANCIAL PROFESSIONALS

NOT FOR CONSUMER USE.

[PRESENTED BY:]

Joe Sample, [Designations per field stationery guidelines][Company Approved Title][Agency Name] [The Prudential Insurance Company of America][if Agency Distribution][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] [[email protected]]

BUSEINESS STRATEGIES

Exit Strategies Using Life Insurance For The Closely Held Business

© 2014 Prudential Financial, INC.. and its related entities.

0190548-00006-00 Ed. 06/2014 Exp. 02/26/2016


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.

2 NOT FOR CONSUMER USE.

Securities and Insurance Products: Not Insured by FDIC or Any Federal Government Agency. May Lose Value.

Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate.



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”


Business Continuation Planning

The Need

• Small businesses (employ under 500 employees) comprise over 99.7% of all employer firms in United States*

• 19% of family business owners have not completed any estate planning other than a will**

• Only 32% have a written strategic plan**

*Statistics www.sba.gov/advo/research updated January 2011 FAQ

**LIMRA Market Facts Quarterly (Spring 2009)



Before a Solution

Before you propose a life insurance solution, do you know:How the business is organized?

• Public or private corporation

• Pass-through entity

• Partnership

• Limited Liability Company (LLC)

• S Corporation: Always an S corporation?

• Tax-exempt entity



Before a Solution

Do you 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?



Before a Solution

Do you know:General Numbers

• Salaries (including bonuses and “perks”)

• General value of the business

• Total number of employees

• Number of key employees



Before a Solution

Do you know:Soft Facts

• Relationships• Family members• Business owners/employees• Management style

• Who is the obvious power person?

• Who is the not so obvious power person?




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.




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




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)



Exit Strategies

Exit strategies include:• A formal written buy-sell agreement• A proper business valuation• A funding mechanism



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

Establishing Value for Estate Tax Purposes

Three-Point TestBuy-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.



Establishing Value for Estate Tax Purposes

Family TransactionsAdd “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




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


Proper Business Valuation

StandardsInternal 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




Business Valuation

Methods

Multiple Approaches but Two Basic ConceptsLiquidation 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?



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 tax-free. Life insurance proceeds are otherwise generally income tax-free under IRC §101(a).



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 solution to build “basis” when future distributions are anticipated.

• Permanent policies, when appropriately funded, can provide buyers with the opportunity to accumulate cash values on a tax-deferred basis.



Life Insurance

Term vs. PermProvides 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.


Buy-Sell Structures

Basic• Stock Redemption Plan

• Entity Buyout (partnership/LLC)

• Cross Purchase Plan

• Wait-and-See Plan


Stock Redemption Arrangement/Entity Buyout

• Agreement between business and each shareholder• Business is owner, premium payer, and beneficiary of insurance on life of each shareholder


Corporation Shareholder A

InsuranceCompany Shareholder B

Premium Proceeds

Agreement

Agreement



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



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)



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.


Cross Purchase Arrangement


Shareholder A Shareholder B

InsuranceCompany

Agreement

Premium

PremiumProceeds

Proceeds

• Agreement between shareholders• Shareholder is the owner and beneficiary of insurance on other shareholders



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



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



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



Cross Purchase

Multiple Policy ManagementSolution? 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



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



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.



After the Buy-Sell Arrangement Is In Place

The Process Is Not OverMaintenance is Critical• Updates to the buy-sell agreement• Current appraisals to justify the business value• Is funding adequate? • Have circumstances changed?


Questions?
