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Posting by: David M. Morris, JD, CLU
Date: March 1, 2010
On a recent visit to our grandchildren in DC, my wife and I shared moments of both pride and wistfulness as we watched our children parenting THEIR children. In an instant, it seemed everything had changed—or had it?
From the moment our kids took their first uncertain steps years ago, they have been changing and growing. Preparing for those changes and adjusting to them has been our job as parents, and now grandparents.
Continuity of a business often turns on the financial ability of the entity to adjust to change. Succession of leadership and ownership is, by definition, change. The sudden change triggered by the death of a family member can erode capital, reduce access to credit, create new liabilities and impact profits.
The proper use of life insurance for business continuity can go a long way toward preserving the entity and providing security for family members.
Insurance Techniques Used to Ease Succession in Family Businesses
As a general rule, family shareholder interests should be repurchased by the business (or remaining shareholders) at the death of a shareholder, otherwise ownership could well pass to non-family members. A family business interest left to a spouse at the death of a family member might ultimately end up controlled by a subsequent spouse. For example, a family member dies and leaves his business interest to his wife. She remarries but dies shortly after, leaving those shares to her new spouse – not a good situation for other family members.
The corporation should own life insurance itself, or simply pay the premium on policies owned by shareholders on each other, so that each interest can be purchased at death. The shareholder's beneficiaries get cash and the business retains control of the stock.
Often an arrangement is made under a succession plan that a parent's interest will be left to an adult child at the death of that parent. This straightforward structure works, except ... suppose the child dies first?
Preparing for Succession in a Family Business
If this occurs, the business may lose a key, profit-producing person, its future as an income source for retiring family members and its best opportunity for growth – all in one event. Life insurance on the child brings cash back into the business. It buys time and flexibility for the parent to adjust to this huge change and provides capital to repurchase that child's stock, time and capital to recruit a replacement or to attract a new market for the sale of the business.
Under the current tax law, death usually creates new liabilities for a family business. Sometimes access to capital is reduced if a key family player is lost – banks are reluctant to lend, equity sources are reluctant to invest and yet the government seeks payment for estate taxes. Properly arranged, life insurance policies bring cash to pay taxes, pay off credit lines or enhance balance sheets to attract more capital.
Commitment Necessary in Applying Succession Techniques
Commitment is necessary by both founders and other family business shareholders to put succession techniques into place. Make plans – an estate plan, a business strategic plan and a plan for the succession, including the choice of the successor (based on objective criteria). Share this plan with the family and other shareholders. Put in place proper agreements and the insurance policies necessary to fund them. Transfer the business in a step-by-step process according to an agreed-upon plan.
Perhaps, most importantly, founders should prepare for retirement, both financially and in lifestyle preparation. A secure source of income outside of the business and fulfilling activities to engage in after retirement are essential to making the succession a success.
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