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Business Continuation Planning Strategies Page 1 Business Continuation Planning Strategies Using Cash Value Life Insurance to Help Ensure Successful Transitions 17-92C Pacific Life Insurance Company
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Page 1: Business Continuation Planning Strategies · Business Continuation Planning Strategies Page 5. B. Cross Purchase. A Cross Purchase arrangement is a type of business succession plan

Business Continuation Planning Strategies Page 1

Business Continuation Planning StrategiesUsing Cash Value Life Insurance to Help Ensure Successful Transitions

17-92C

Pacific Life Insurance Company

Page 2: Business Continuation Planning Strategies · Business Continuation Planning Strategies Page 5. B. Cross Purchase. A Cross Purchase arrangement is a type of business succession plan

Business Continuation Planning Strategies Page 2

1.

2. Why is Exit and Continuation Planning Essential?

3. Benefits of a Business Succession Plan

4. Buy-Sell Agreements

5. Buy-Sell Strategies: Comparing the Optionsa. Entity Purchase / Stock Redemptionb. Cross Purchasec. One-Way Buy-Selld. Wait-and-See Buy-Sell

6. Funding the Buy-Sell Plan with Life Insurance

7. The Added Benefits of Cash Value Life Insurance

8.

1 Planning ahead for the succession and future continuity of a business is vital to protecting both the long-term viability of the enterprise and helping business owners receive the maximum value for their financial interests upon their exit.

In addition, having a business continuation plan in place may help provide for a more successful retirement. While a business is typically a source of current income for many business owners, the value of the business may also represent a critical future source of income.

A recent survey shows that a third of small business owners do not have a retirement savings plan1. Instead, the retirement plan for some business owners may simply be to sell their business interest when the time comes. This can be a risky strategy that may not account for changes in the economy, emergencies, and unexpected business downturns that can significantly impact the price of the business and ultimately the value of the retirement ‘package’ that is expected.

Business continuation strategies are therefore critical not only for the immediate survival of the business, but to help ensure that the business can be relied upon to generate the expected value for owners when they exit the business.

1 “5 Ways Small Business Owners can Start Preparing for Retirement”, Jared Hecht, Forbes, November 27, 2018 https://www.forbes.com/sites/jaredhecht/2018/11/27/5-ways-small-business-owners-can-start-preparing-for-retirement

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One goal of every business owner should be to be able to answer five basic questions regarding their business continuation strategy:

1. To whom will the business be transferred? (e.g., co-owner, child, key person, 3rd party)2. How will this occur? (e.g., will, gift, sale)3. If the business is to be sold, what will the price be? (e.g., specific amount, multiple of earnings, 3rd party appraisal)4. How will the buyer pay for the business? (e.g., lump sum, installment payments)5. When will the exit occur? (e.g., death, disability, retirement)

Under the best of circumstances, a business owner may be able to answer the first four questions, but the fifth may be impossible to predict. It is important to consider the possibility that this exit could come sooner than anticipated and to prepare accordingly.

Without proper planning, the sudden death, disability, or departure of a small business owner may not only have a devastating impact on the business, the business’s employees, and the other owners of the business – it may also have a significant financial impact on the business owner’s family. The reality is that less than 25% of business owners have a plan in place2. What’s more, among family businesses, only 30% last into a second generation, 12% remain viable into a third, and 3% operate into the fourth generation or beyond3.

The unexpected exit of the business owner when there is a lack of a properly structured business exit & continuation plan (i.e., a Succession Plan) may:

2 Why is Exit & Continuation Planning Essential?

• Leave the business’s operations severely hampered.• Leave the business owner’s family without its primary source of income.• Leave the business owner’s shares without a resale market.• Create a conflict between the remaining business owners and the decedent business owner’s estate regarding the

future direction and ownership of the business.• Leave the business or remaining shareholders with the desire to buy the exiting owner’s shares, but lacking an agreed

upon price or the available funds to complete the transaction.

Conversely, a formal succession plan can help prepare the business for an orderly transition regardless of the circumstances… whether it is the planned exit of a business owner or an unexpected event that could have a devastating impact.

2 Business Owners, What’s Your Succession Plan?”, Charles Massimo, Forbes, June 5, 2019 https://www.forbes.com/sites/forbesnycouncil/2019/06/05/business-owners-whats-your-succession-plan3 “Leadership Lessons from Great Family Businesses”, Fernandez-Araoz, Iqbal, and Ritter, Harvard Business Review, April, 2015 https://hbr.org/2015/04/leadership-lessons-from-great-family-businesses

A succession plan may help answer the question of what happens to a business after the planned or unplanned exit of a business owner. A plan can also allow for continuity of management, a source or income for the business owner or his or her family, and a clear direction for the future ownership of the business.

A properly structured plan may provide the parties with:

3 Benefits of a Business Succession Plan

• Continuity of management and control for the remaining owners• A source of income for the decedent business owner’s family• A captive market for often non-marketable business interests

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And in the event of a business owner’s death, may provide:

• Liquidity to the decedent’s estate for estate taxes and administration costs• A fair valuation of the business interest for federal transfer tax purposes4, 5

• A fair return to the decedent’s estate for his or her business interest.4 According to the Tax Cuts and Jobs Act of 2017, the federal estate, gift and generation skipping transfer (GST) tax exemption amounts are all $10,000,000 per person (indexed for inflation effective for tax years after 2011); the maximum estate, gift and GST tax rates are 40%. In 2026, the federal estate, gift and generation-skipping transfer (GST) tax exemption amounts are scheduled to revert to $5,000,000 per person (indexed for inflation for tax years after 2011).5 Although an agreement may not be controlling for federal gift tax purposes, it can carry weight as to the business value when considered along with all relevant information. Consult appropriate tax and legal counsel for guidance on valuing a business interest for Federal Transfer Tax Purposes.

4 Buy-Sell Agreements

A primary component of a typical succession plan is a buy-sell agreement. A buy-sell agreement is a legal contract providing the terms and conditions for the disposition of a business owner’s interest in the event of death, disability, retirement, or other exit from the business. It generally includes the parties to the agreement, the purchase price, payment terms and funding arrangements. Under a buy-sell agreement, a specified party has either the obligation or the option to purchase a departing or deceased business owner’s interest in the business.

Valuation methods for the business owner’s interest vary. It is generally advisable to work with a 3rd party appraiser in defining the value for buy-sell purposes and establishing the purchase price. A well-structured buy-sell agreement can even anticipate how the value of a business may change over time, as well as provide for appropriate adjustments in the amount of the buyout price.

5 Buy-Sell Strategies: Comparing the Options

Most buy-sell agreements are structured in one of four ways: an Entity Purchase, a Cross Purchase, a One-Way Buy-Sell, or a Wait-and-See Buy-Sell. The basic difference between these structures is who sells and who purchases the business interest. Each strategy has specific tax and legal ramifications that should be considered with the guidance of appropriate tax, legal, and financial advisors.

An Entity Purchase or Stock Redemption arrangement is a type of business succession plan which may best be suited for a business with three or more business owners. The entity purchase plan requires the business to purchase a departing or deceased business owner’s interest in the business at an agreed upon price. The agreement can apply to one or more of the existing owners (i.e., it can apply only to those owners that choose to participate).

Working with their legal, tax and financial advisors, the business and the business owners enter into an entity purchase agreement. The agreement will require the business to purchase the participating business owners’ interests in the business for an agreed upon or determinable price upon the occurrence of a triggering event (e.g., death, disability, or retirement).

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Page 5: Business Continuation Planning Strategies · Business Continuation Planning Strategies Page 5. B. Cross Purchase. A Cross Purchase arrangement is a type of business succession plan

Business Continuation Planning Strategies Page 5

B. Cross Purchase

A Cross Purchase arrangement is a type of business succession plan best suited for a business with few business owners. The Cross Purchase arrangement requires departing business owners or the estates of decedent business owners to sell their interest in the business to the remaining business owners at an agreed upon or determinable price. The agreement typically applies to all existing business owners.

C One-Way Buy-Sell

A One-Way buy-sell arrangement is designed either for (1) an owner of a business who wants to sell to someone who does not currently have an ownership interest or (2) an owner of a business who wants to arrange for the sale of his or her business interest to one or more co-owners who have no reciprocal intent to sell. The buyer in this design may be a key executive, a family member, or third-party to whom the business owner wants to transfer the business. The One-Way buy-sell helps ensure that the business owner can sell his or her business interest to an appropriate buyer.

D. Wait-and-See Buy-Sell

The Wait-and-See buy-sell arrangement allows business owners to postpone the choice between an Entity Purchase and a Cross Purchase until the death or departure of a business owner.

Working with their legal, tax, and financial advisors, the participating co-business owners enter into a Wait-and-See Buy-Sell agreement. The agreement will require the business and the participating business owners to purchase a decedent or departing business owner’s interest in the business for an agreed upon or determinable price upon the occurrence of a triggering event (e.g., death, disability, or retirement). Typically, the agreement grants the business the first right of refusal to purchase the decedent or departing business owner’s interest in the business, and a secondary option to the remaining participating business owners to purchase any portion of the business interest not purchased by the business. Any shares not purchased through the exercise of these options must, in most cases, be redeemed by the business.

6 Insurance

Identifying a buyer and creating a formal buy-sell agreement setting the purchase price and sale triggers are often the first steps in formalizing a business succession plan. Of equal importance is determining how these arrangements will be funded. As is true with many planning issues, those who make arrangements ahead of time can typically achieve the desired result more effectively and often with lower costs.

For this purpose, businesses and business owners often use life insurance as a funding vehicle to finance the obligations and planned purchases under a buy-sell agreement.

The implementation of a business succession plan using life insurance is often quite simple. With the assistance of the business’s tax, legal, and financial advisors, the business owners will choose which buy-sell structure is most appropriate for their needs. The attorney then drafts a buy-sell agreement which contains the parameters for the arrangement, including, but not limited to, the possible triggering events for the buy-sell (e.g., death, disability, retirement) and how the purchase price will be determined.

The parties involved in the buy-sell agreement will then purchase life insurance through a financial professional6 on the business owner’s life. The party that has the obligation or the option to purchase the deceased or departing business owner’s interest is generally the owner and beneficiary of the life insurance policy, with the intent of using a distribution from the policy as a primary source of funding.

Funding the Business Succession Plan with Life

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• The cash value of the policy may be used as part of a lifetime buyout. Often, a buy-sell occurs for a reason other thanthe death of a business owner (e.g., retirement, disability, or attainment of a specified date). For example, the policyowner may use any available cash value in the life insurance policy to pay for part of the buyout price at a businessowner’s retirement.

• The insured(s) may not have to re-qualify for insurance. At the end of a fixed duration term life insurance policy, ratesmay increase dramatically. At this point the purchase of a new term life insurance policy may be cost prohibitive.

• If the arrangement is an Entity Purchase / Stock Redemption, the business may book the policy cash value as anasset and may access any available policy cash value for emergencies or other financial needs.

• If the arrangement is a Cross Purchase or a Wait-and-See buy-sell, the policy owners/business owners may accessany available cash value for emergencies or other financial needs.

• If circumstances change and the business succession plan and insurance are no longer needed, cash value lifeinsurance may be surrendered for its cash surrender value. This residual value is typically not available with mostterm insurance products.

Some business owners may initially consider term insurance to fund their business continuation plan. While using term life insurance may suffice in some arrangements, in many cases cash value life insurance policies are more appropriate. Although a term policy may be less expensive in the early years of the arrangement, term insurance only provides funding in the event of one contingency – the death of the insured – and does not help in the event an owner is being bought out upon departing or retiring from the business.

Cash value life insurance policies may provide the parties in a buy-sell agreement with the following benefits when compared to term life insurance:

In the event of the insured business owner’s death, the beneficiary of the life insurance policy receives the policy’s death benefit. The beneficiary can use the death benefit proceeds to fund the purchase of the decedent’s shares of the business as outlined in the business continuation plan.

6 In order to sell life insurance, a financial professional must be a properly licensed and appointed life insurance producer.

7 The Added Benefits of Cash Value Life Insurance

A little planning can go a long way toward providing financial security. A well-designed business continuation plan funded with life insurance and developed with the guidance of experienced legal, tax, and financial advisors can help business owners protect their family’s financial future and the future of their businesses.

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• If the arrangement is structured as an Entity Purchase / Stock Redemption, the business will generally be the ownerand the beneficiary of the life insurance policy.

• If the arrangement is structured as a Cross Purchase, the co-business owners will generally be the owner andbeneficiary of the life insurance policies.

• If the arrangement is structured as a One-Way Buy-Sell, the intended purchaser (often a key executive, a familymember, or third-party) will generally be the owner and beneficiary of the life insurance policy.

• If the arrangement is structured as a Wait-and-See Buy Sell, the typical arrangement is for the co-business owners tobe the owner and beneficiary of the life insurance policies.

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Pacific Life Insurance Company is licensed to issue insurance products in all states except New York. Product availability and features may vary by state. Insurance products and their guarantees, including optional benefits and any crediting rates, are backed by the financial strength and claims-paying ability of the issuing insurance company. Look to the strength of the life insurance company with regard to such guarantees as these guarantees are not backed by the broker-dealer, insurance agency, or their affiliates from which products are purchased. Neither these entities nor their representatives make any representation or assurance regarding the claims-paying ability of the life insurance company. Pacific Life Insurance Company’s Home Office is located at 700 Newport Center Drive, Newport Beach, CA.

This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life, its affiliates, their distributors and respective representatives do not provide tax, accounting or legal advice. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor or attorney.

Pacific Life is a product provider. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.

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17-92C


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