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Business Succession Planning:

Business Succession Planning

Need for Succession Plan

Need for Asset or Buy/Sell Strategy

Need for Liability or Key Person Strategy

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Simple Succession Plan:

Simple Succession Plan

 

Complete Succession Plan:

Complete Succession Plan

Strategy

Financial Needs

Insurance Funding

Retirement Funding

 

One Page Strategy:

One Page Strategy

Asset Needs

Liability Needs

Personal Needs

Who Pays the Premiums?

Valuing the Business

Simplifying the Valuation Issue

Equity vs. Loan Capital

 

One Policy Strategy:

One Policy Strategy

Flexibility

Dual Role of Personal Cover

Dual Role of Debt Red'n Cover

Security & Tax-Effectiveness

Cost Savings

Pre-Agreed Purchase Price

Apportionment of Premiums

Methods of Aggregation

 

Multiple Policy Approach:

Multiple Policy Approach

Super Fund Ownership

Tax Disadvantages

Cost Disadvantages

Other Disadvantages

Geared Premium Funding

Super Buy/Sell

 

One Page, Two Policy Strategy:

One Page, Two Policy Strategy

 

Other Issues:

Tax Deductibility

Inadequate Insurance Proceeds

Vendor Finance

Changing Needs

Future Growth of Equity

Trauma Buy/Sell Strategy

 

Sole Proprietors and Families:

Sole Proprietors and Families

Overview

Family Ownership

Sale Strategies

Third Party Buy/Sell Strategies

Estate Equalisation Strategies

Family Buy/Sell Strategies

Second Generation Strategies

Debt Reduction Strategies

 

 

 

Family Buy/Sell Strategies

 

When is a Family Buy/Sell Strategy Relevant?

A Family Buy/Sell Strategy is relevant, if the cost of an Estate Equalisation strategy is prohibitive, because of the number of children who do not wish to acquire an interest in the Business.

Often where an Estate Equalisation strategy is difficult or only partially successful, Estate Equalisation Insurance is used to remedy the inequity.

See here for a discussion of Estate Equalisation.

 

Buy/Sell Agreement between Parent and Interested Child

An alternative strategy to Estate Equalisation Insurance would be to enter into a Buy/Sell arrangement with the interested child.

Because a Will can be the most tax- and cost-effective method of transmitting a Business and Property to the Second Generation, Buy/Sell Strategies are not commonly used for inter-generational transfers.

However, they can be a more cost-effective method of addressing testamentary inequities than Estate Equalisation Insurance.

 

Using Estate Equalisation Insurance to Remedy Inequities

Often where an Estate Equalisation strategy is difficult or only partially successful, insurance is used to remedy the inequity.

This strategy uses insurance to "gross-up" the total value of the Estate, so that:

  • the interested child receives the Business or Property; and

  • the remaining children receive Insurance Proceeds equivalent in value to an interest in the Business or Property.

 

Estate Equalisation Example

For example, if the Equity in the Business was worth $1 million:

  • the interested child would inherit the Business worth $1M; and

  • each other child could receive Insurance Proceeds of $1 million (subject to the value of any other assets they might inherit).

This strategy requires a total sum insured of $1 million per child (other than the child who will inherit the Business).

If there are two other children, the sum insured will be $2 million. If there are three other children, the sum insured will be $3 million.

In each case, each child would receive an asset or Insurance Proceeds worth $1 million.

 

Family Buy/Sell Strategy

A Family Buy/Sell Strategy effectively requires the interested child to obtain Buy/Sell Insurance with respect to the Proprietor.

This enables the interested child to purchase the Equity from the Estate (rather than inheriting it).

In contrast to Estate Equalisation Insurance, the Buy/Sell Sum Insured need only be $1 million in order to allow the interested child to purchase the Equity from the Estate with the Insurance Proceeds.

This strategy makes it necessary to insure only the Sale Price of the Equity in the Business (rather than an equivalent amount for each child not interested in the Business).

 

Effect on Estate

The strategy effectively replaces the asset with its cash value (i.e., the Net Sale Proceeds).

The Net Sale Proceeds (plus any other assets in the Estate) could then be distributed equitably between all of the children (including the child who has purchased the Business).

In the above example, the Estate would swap the Equity in the Business for the $1M Insurance Proceeds.

The $1M cash can then be distributed to the Beneficiaries in accordance with the Will.

As a result , it is not necessary to "gross-up" the Estate to a higher amount (i.e., at the rate of $1M per child) in order to facilitate an equitable distribution.

 

Lower Sum Insured Required

In the above example, an Estate Equalisation Strategy would require a total sum insured of $1 million per child (other than the child who will inherit the Business).

In effect, the Estate must be "grossed-up" by $1M per child.

The more children, the more expensive is the strategy.

A Family Buy/Sell strategy requires only $1M Cover in total.

For example, if there are two other children, the total sum insured would be $1 million, not $2 million.

If there are three other children, the total sum insured would be $1 million, not $3 million.

In each case, the Estate will consist of Sale Proceeds of $1 million, which can then be distributed equally between the children.

The value of the Estate remains the same.

 

Combination of Family Buy/Sell Strategy and Testamentary Gift

The standard version of a Family Buy/Sell Strategy entitles the interested child to share in the assets of the Estate (including the Sale Proceeds with respect to the Business).

This means that the interested child could effectively recover a share of the Insurance Proceeds that have enabled them to acquire the Business.

Thus, they could end up with both the Business and a share of the Insurance Proceeds.

There is nothing particularly wrong with this outcome, especially if the interested child could use the additional cash to reduce debt or fund working capital.

However, the real problem is the premium cost of the strategy.

In a sense, this version of the Strategy incurs a premium cost that might be more than is strictly required.

If cost is a dominant issue, it is possible to combine a Family Buy/Sell Strategy and a Testamentary Gift.

Testamentary Gift of Part of Business to Interested Child

The standard version of the Strategy involves a purchase of the whole of the Business by the interested child (e.g., for $1M).

If there were two children, then arguably each child would be entitled to half of the Business (i.e., $500K each).

The Combined Strategy involves:

  • a purchase of part of the Business (e.g., 50%) by the interested child; and

  • a gift of part of the Business (e.g., 50%) to the interested child.

Two Children

In the case of two children:

  • the interested child would purchase 50% of the Business for $500K;

  • the interested child would be gifted 50% of the Business pursuant to the Will (value: $500K); and

  • the other child would receive a gift of $500K (which would be funded by the Buy/Sell Insurance Proceeds).

The Combined Strategy would reduce the Sum Insured from $1M to $500K.

Three Children

In the case of three children:

  • the interested child would purchase 66% of the Business for $666K;

  • the interested child would be gifted 34% of the Business pursuant to the Will (value: $334K); and

  • the other two children would receive a gift of $666K or $333K each (which would be funded by the Buy/Sell Insurance Proceeds).

The Combined Strategy would reduce the Sum Insured from $1M to $666K.

More Children

The more children, the greater the need for Buy/Sell Insurance.

Reliance on Will

The Combined Strategy relies on the terms of the Will to gift part of the Business to the interested child.

This component of the strategy introduces an element of risk, if the Will is challenged or varied without the consent of the interested child.

However, particularly in smaller Families, it can substantially reduce the premium cost of a Family Buy/Sell Strategy.

 

Payment of Premium

Because the interested child will receive the benefit of the Insurance Proceeds, it would be appropriate for them to pay the Premium.

However, this is an issue for the family to determine.

 

Determination of Purchase Price

The Purchase Price should normally be the market value of the asset (or at least within market parameters).

However, in cases where the interested child has contributed to the value of the asset (e.g., by working for less than a market salary), it would be appropriate to consider a lower Purchase Price in recognition of the child's contribution.

In a sense, some of the current value of the asset might be attributable to the child.

Therefore, it might not be appropriate to charge the child to acquire that amount.

 

CGT Liability

One benefit of this strategy is that the Capital Gains Tax with respect to the disposal of the Equity in the Business can be paid out of the Insurance Proceeds.

In addition, the interested child will now have a substantive market value cost base for their Equity (rather than inheriting their parent's lower cost base).

 

Second Generation Succession Planning Strategies

Ultimately, ownership of the Business will be transferred to the Second or Next Generation.

This Generation has its own Succession Planning needs.

In many cases, it is possible to start working on these needs before they acquire ownership of the Business.

Click here to read more about this topic.

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

In the case of Retirement, a Complete Succession Plan can pre-agree the Purchase Price and specify a timeframe for payment.

If you do not have adequate insurance for an Insurable Event, your Succession Plan can specify a timeframe for payment of the shortfall.

See more Adviser Tips

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