The Buy-Sell Agreement | October 2001 Managing Money

Managing Money: The Buy-Sell Agreement

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Tell your clients about the changes Congress has made to the estate tax laws.

Janet C. Arrowood

Most financial advisors know how important a funded buy-sell agreement is for ensuring the orderly transfer of a closely held business. However, convincing business owners has never been easy, and the graduated (and temporary) repeal of the estate tax has given many of them a false sense of security.

There are several key items to consider:

The Unified Credit will increase gradually until 2010. For a very brief period there will be an unlimited Unified Credit so that there will be no estate taxes.

In 2011, the tax code will revert to a credit based on $1 million being estate-tax free unless new laws are passed (Sunset Provision). When this Sunset Provision takes effect (even if modified to allow, for example, $3.5 million as the basis for the Unified Credit), clients will be 10 years older

Clients already tend not to fund buy-sell agreements or update them.

Clients are likely to surrender existing insurance policies.

Businesses will still be illiquid and not readily saleable.

It's important to review these items as well as their implications.

Increasing the Unified Credit. This is the amount of federal estate taxes that would be due on a certain amount of a deceased's assets (currently the taxes that are due on $675,000). This amount had been scheduled to increase through 2006 until the estate-tax-free amount reached $1 million. Under the new law, this amount will increase to $3.5 million in 2009, become unlimited in 2010 and revert to $1 million in 2011. This means that for a nine-month period, there would be no tax due on a business (as part of an estate) of any value. However, if your client hasn't planned his or her death carefully, there will still be an estate tax problem.

The Sunset Provision. While few people believe that our tax code will revert to the 2006 estate tax exclusion (based on $1 million), even fewer seem to believe we can afford never to reimpose some level of estate taxes. This amount may be based on several million dollars, but many closely held businesses and organizations will be worth much more than that in 2011.
Insurability. Clients will be 10 years older, which will make life and disability income insurance more difficult and expensive to obtain.

Funding and Other Buy-Sell Agreement Components. A properly setup buy-sell agreement has four major components. These are a legal agreement, a valuation process, a tax-implications analysis as well as a funding vehicle.

In most cases, clients do nothing. In some cases, they have a formal legal agreement. In even fewer cases, they have valued the business and looked at the tax implications. Once in awhile they even consider how to pay for everything and decide to use the company line of credit. Unfortunately, that line of credit tends to end with the first owner who dies or becomes disabled.

Surrendering Existing Policies-Business Liquidity Issues. Many so-called advisors are already recommending that clients surrender many life insurance policies intended to pay estate taxes. The justification is that Congress will never be able to put the estate tax back once it has gone away. They may be half right. Congress will probably never put it back to the levels of 2001, or even 2006, but may settle on the 2009 levels. The issue that many clients don't think about is the need for liquidity. When a key person dies, many customers take their business elsewhere. Banks are not willing to lend additional money, and loans often have a "call" provision. Money dries up while expenses stay the same or increase.

Business Valuations. As the economy and markets recover, the value of many businesses will increase. If the Sunset Provision, or a version of it, is allowed to take effect, the need for insurance to provide liquidity and pay estate and other taxes will be greater than it is today.

Possible answers

There are several solutions to these unintended consequences. You can meet with your clients now and tell them why they must keep their current insurance. If they don't have a funded buy-sell agreement, they should get one. And don't forget the disability provisions.

If your clients are reluctant to do this, show them the virtues of guaranteed-level, fully convertible term life insurance. For a small sum, they can buy a term life insurance policy on each owner who has (in most states) guaranteed premiums through 2011 and conversion privileges for at least that long. Then, if the Sunset Provision does not occur and the estate tax is not reinstated, the clients can surrender the term policies. If the estate tax is reinstated in some form, your clients have ensured liquidity and the ability to pay these taxes without their heirs selling the business at a fire sale.

The recent actions of Congress go far beyond the (temporary) changes to the estate tax laws. There have been changes in contribution levels for almost every type of qualified retirement plan, changes in tax rates and brackets, and changes to the dreaded Alternative Minimum Tax rates and structure. Tax rates on long-term capital gains have been reduced. Providing this information to your clients is a valuable service and helps you preserve existing business and identify new opportunities.

Janet Arrowood is the owner of Continuing Education Unlimited, Inc.-The Write Source, a Colorado-based financial services writing and training company. She is also a registered representative with The Leaders Group, Inc. She can be reached at jc_arrow@hotmail.com.

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