Perhaps no market holds as much potential for financial professionals to meet needs as the Asian-American small- business market. As a recent Washington Examiner article shared: “Asian-Americans have excelled in virtually every field and occupation imaginable, but there continues to be a strong tradition of entrepreneurship. There are now almost 2 million Asian-owned small businesses.”
Furthermore, according to the article, “Small businesses as a whole support nearly half of all private sector employees and account for nearly two-thirds of new jobs. Asian-owned small businesses already employ over 3.5 million people, but that number will continue to rise as more young Asians are starting businesses and doing so in higher numbers than any other demographic.”
In the burgeoning Asian-American entrepreneurial community, opportunities abound to help with business succession planning. Some Asian-Americans have not taken steps to ensure a smooth transition of their small businesses simply because of language challenges or cultural barriers they may encounter with a non-Asian advisor. Therefore, carrier-provided, in-language educational materials and the support of bilingual carrier staff can be crucial in successfully meeting needs.
Cash-value life insurance — in particular, indexed universal life solutions — can also be instrumental in serving business succession needs in the Asian-American market. When a business owner dies, the financial consequences depend largely on how well the business has prepared for a transition of ownership. Buy-sell agreements that are fully funded with IUL insurance are designed to address numerous key challenges.
What Surviving Owners Want
Surviving owners typically look to retain total control of the business without interference from the deceased owner’s heirs. They may also expect that the heirs will sell them the deceased owner’s interest promptly and at a fair price. Most important, they want to retain the loyalty and support of employees, customers and creditors during and after the change in ownership.
What Heirs Want
The deceased owner’s heirs want ongoing financial security, especially after the loss of the owner’s salary and benefits. Heirs typically expect prompt settlement of the deceased owner’s estate, including a proper valuation of the business interest if they plan to sell it. The family may want to retain the business interest or sell it promptly at an attractive price.
When there is no formal buy-sell agreement addressing what will happen when an owner dies, unhappy consequences can result. Litigation between the deceased owner’s heirs and surviving owners is not uncommon. Delays in settling the deceased owner’s estate and conflicts with surviving owners can result in loss of customers, employees and creditor confidence. These outcomes can damage the business — and possibly even force liquidation, the worst possible result.
A formal, written buy-sell agreement between the business owners is the first step in ensuring an orderly, successful transition following an owner’s death. Buy-sell agreements are complex instruments and, therefore, consumers should consult their legal and tax advisors regarding creation of such documents. But they are designed to serve the needs of small- business proprietors well.
An IUL insurance product may be the best source of funding for many buy-sell arrangements. As permanent life insurance, IUL products offer death benefit protection as well as the potential for cash value accumulation.
Also, IUL insurance is designed to help guard against market volatility, while providing clients alternatives to supplemental retirement income. Although IUL policies are not investments, they credit interest based on the performance of an underlying index strategy selected by the client and the upward movement of the index or multiple indices. It is important to note that index interest crediting accounts do have limitations, such as participation rates or rate caps, which can limit or reduce the interest earned. Therefore, always see the contract for additional information.
A legally binding buy-sell agreement is designed to:
» Establish a fair price for the business interest and terms of sale that are acceptable to all parties.
» Establish a value for estate tax purposes, which helps avoid estate settlement delays and IRS challenges. (A professional appraisal of the business should be performed; seek legal counsel for advice on this subject.)
» Establish the basis for determining the amount and funding of life insurance needed to fund the purchase of the business by heirs or others.
» Encourage confidence in the ongoing vitality of the business in the eyes of customers, creditors and employees.
There are three primary types of buy-sell agreements. While this article provides a brief overview of each type, it’s important to review the attributes of each in greater detail to determine the type of agreement to put in place.
In a cross-purchase agreement, each owner buys part of the interest. Each owner buys insurance on every other owner to fund the purchase. To provide funding, each owner buys a life insurance policy covering the life of every other owner. Each person owns and is the beneficiary of each individual policy.
For example, assume a partnership valued at $750,000 is owned by three equal partners — Kwan, Zhang and Dao. With a cross-purchase agreement, each partner buys policies on the lives of the other two in the amount of $125,000 each, so that each partner is insured for a total of $250,000. If Kwan dies, the death benefits on the two policies insuring his life — one owned by Zhang and one by Dao — are paid to the two surviving partners as beneficiaries of the policies. Together, the surviving partners have a total of $250,000 to purchase Kwan’s business interest from his heirs.
With a cross-purchase buy-sell agreement in place, surviving owners are assured of having the funds to buy out a deceased owner’s heirs and maintain control of the business. Although all the terms of the sale are decided in advance, the agreement should provide a mechanism (a periodic stock revaluation clause, for example) so that heirs receive a fair price for the deceased’s interest. Surviving owners receive an increase in basis that can reduce the capital gains tax on a future sale of the business interest. Be sure, however, to tell clients to consult a qualified tax expert regarding their own situation.
Entity Purchase Agreement
With an entity purchase agreement, the business buys insurance on each owner to fund the purchase, with the business entity designated as the owner and beneficiary of each policy. The business must give notice that it intends to insure the owner-employees and must also secure each owner-employee’s written consent.
The amount of insurance approximates the agreed-upon purchase price for each owner’s interest. The agreement stipulates either a specific purchase price or a formula for determining the purchase price. Life insurance proceeds provide the funds to buy the deceased owner’s interest.
Although premiums paid for the insurance are not tax deductible, death benefits are generally excluded from federal income tax when the notice and consent requirements have been met. Redemptions that meet certain requirements can avoid being taxed as dividend distributions.
An entity buy-sell agreement is preferable when there are many owners, since this arrangement requires that the business purchase only one life insurance policy on each owner. A cross-purchase agreement requires that every owner buy a policy on every other owner.
An entity agreement may also be preferred when there is a wide age disparity among the owners, because younger owners would bear a greater premium burden to insure older owners under a cross-purchase agreement. If the business wants access to policy cash values, the business must own the policy. This is not possible in a cross-purchase agreement, where individuals are the policy owners.
In a one-way agreement, an individual (usually a key employee) agrees to buy a sole-owner business. The buyer typically purchases life insurance on the owner in an amount equal to the purchase obligation under the agreement. The agreement may require the buyer to maintain the policy by paying the premiums when due.
The agreement usually provides that the buyer will not assume the business liabilities. The sole owner’s executor may use cash from the purchase to pay off the liabilities, as well as other estate costs and taxes. The balance is distributed under the terms of the owner’s will to the estate beneficiaries or, perhaps, to a trust for their benefit.
As the policy’s owner and beneficiary, the buyer is obligated to notify the owner before exercising any policy rights that might affect the policy value. Similarly, the agreement may prevent the owner from disposing of key business assets or assigning them as collateral without the buyer’s consent.
The buyer often has a “right of first refusal” on any lifetime disposition of the business by the owner. This means that the owner must first offer the business to the buyer before selling it to a third party during the owner’s life, including at retirement. Only after the buyer declines the option can the owner pursue a third-party sale. Although this clearly restricts the owner’s freedom, it also ensures that the buyer will not pay insurance premiums in vain.
The buyer can make the purchase in installments, providing the installment sale is structured to comply with the Internal Revenue Code’s installment sale rules. This could be particularly useful in the case of a lifetime purchase, when only the policy’s cash value — not the full death benefit — is available to the buyer.
A one-way buy-sell agreement is an effective way to resolve myriad problems that can otherwise affect a one-owner business. The key is to find a willing buyer to complete the agreement — ideally, someone already employed by or familiar with the business.
A properly designed buy-sell agreement represents a clear solution to a series of difficult challenges that Asian-American small-business clients may face. It ensures stability in business transition and prevents heirs from having to run or sell the business after an owner dies. Thus, it can benefit all parties — heirs, owners, employees, customers and suppliers.
Fully funding the buy-sell agreement with IUL insurance may be the most effective way to help ensure the viability of the sale when the time comes. Take the time to learn more from carrier-
provided advanced markets portals and online IUL insurance resource centers. When you have the appropriate resources and in-language support, as well as insights into the culture, traits and values of the Asian-American community, you have the best potential to meet this market’s pressing needs.
Jeff Marsh is senior vice president, life sales, at AIG Financial Distributors. Jeff may be contacted at [email protected]