What Happens When a Business Partner Dies?
Jake and Randy, two close friends, went into business together as young men. Recently out of college, they got together and formed a partnership distributing aircraft parts to small plane mechanics. Soon they formed a corporation, each with 50 percent of the business. Each man attended the other’s wedding. The business was prospering.
Then Randy died in a car accident at the age of 45.
What happened then happens at too many small businesses. Both families had most of their net worth tied up in their small business. When Randy died, though, his 50 percent interest in the company didn’t go to Jake. Instead, in the absence of a will, his share in the business went to his wife, Judy.
Judy, however, was working on a demanding career as an attorney – and was not interested in running a parts business. But of course, as the 50 percent shareholder in the corporation, she was fully entitled to half of any dividend income the business generated.
The problem is that although she was still taking money out of the business, she wasn’t able to contribute to it in any way. She did not have the time, expertise or inclination to learn about the aircraft parts industry, nor develop the list of sales contacts needed to keep the money going.
Randy contributed immeasurably to the business – and Jake was forced to hire a full-time manager to take on most of Randy’s duties. But even he couldn’t quite replace the well-connected and well-respected former owner.
Sales fell, and profits fell even more, thanks to the cost of recruiting and retaining the new manager.
Eventually, revenues fell below expenses, and Jake and Judy were forced to sell the business’s assets to a competitor at a discount price. Jake could not pull enough income out of the business anymore to compensate him for working full time and the risk of operating a small business.
Possible Litigation Consequences
This situation could have been worse: Many times, if you survive the death of a business partner, you aren’t in business with your deceased partners’ wife. You’re in business with your former partner’s widow’s lawyers. And they may not have the same commitment to the long-term survival and success of the business that you do.
The loss of a partner and the sudden involvement of a deceased partner’s heirs can be tremendously disruptive to a small business. Many businesses have undergone a long, arduous and expensive process of litigation as surviving heirs of deceased partners sue, or threaten to sue, to extract money from the company that their loved one built.
It’s a sad story – and usually preventable with some advanced planning.
Purpose of Buy-Sell Agreements
One of the primary tools used by business owners to ensure the long-term survival of a business, plus the fair treatment of all the owners’ heirs, is the buy-sell agreement. The buy-sell agreement is simply a contractual agreement for surviving partners or shareholders to buy out the interest of a deceased partner from his heirs at a pre-determined price, agreed to in advance by all parties.
This price can be a flat fee, revisited every so often as the business grows. Or it can be an agreed upon multiple of revenues or earnings. Whatever makes sense and is agreeable to all parties – without knowing in advance what side of the equation they will be on!
Of course, drafting an agreement is one thing. Raising the cash to buy out the heirs is quite another. Many businesses do not always have the cash on hand to buy out the interest of a partner or shareholder who dies unexpectedly. But life insurance is an ideal tool for this purpose: For a very small premium, the company’s owners can all be assured that there is enough liquidity on the table to take care of the deceased partner’s heirs.
That way, the surviving owners get to run their businesses free of unwanted interference of noncontributing owners – and the heirs get the cash they need to live on in a full and fair settlement for their family member’s interest in the business.
If you use a permanent life insurance policy, the cash value that accumulates can also serve as an important cash reserve for the business, and ultimately to supplement the retirement income of the partners.
Structuring the Agreement
There are multiple ways to structure a buy-sell agreement and the life insurance that provides the liquidity to make that agreement realistic. For example, every partner could hold a life insurance policy on every other partner – an arrangement called a “cross-purchase agreement.” Alternatively, the corporation could be the owner and/or beneficiary of the policy, and it’s the company, rather than the shareholders, that buys out the surviving heirs.
Each arrangement has advantages and disadvantages in tax planning, asset protection, costs, and efficiency or ease of execution. Your agent and attorneys can work with you to create the best arrangement for your individual circumstances.
Disability Buyout Funding
Death isn’t the only thing that can cause the unexpected departure of a partner. If you have a partner who is actively involved in the business, and that individual becomes disabled and can’t work anymore, you have a similar problem – though life insurance wouldn’t pay out for a disability. In this case, you may want to explore having a special disability insurance policy on business owner-employees as well. Again, speak with your agent to develop a plan that suits your business and your circumstances.