Business Succession Planning for the Sole Owner

1. One-Way Cross-Purchase Buy-Sell Agreements Business Succession Planning for the Sole Owner OLA 1957 0509

2. This material was not intended or written to be used, and cannot be used, to avoid penalties imposed under the Internal Revenue Code. This material was written to support the promotion or marketing of the products, services, and/or concepts addressed in this material. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely solely on their own independent advisors regarding their particular situation and the concepts presented here.

3. The Sole Owner – Different from Multi-Owner Companies Problematic – incapacity or premature death No co-owners to run company in interim No obvious successor May cause termination of entity Loss of stream of income for family Fire Sale – loss of significant percentage or ALL value

4. What happens at owner’s death? • Termination of business • Sole Proprietorships • Partnerships • Professional Corporations • Managed by Executor • S Corporations • C Corporations • Limited Liability Companies

5. Bequeathing Business via Will Common approach, but why is this a problem? • Family members: • Children often not involved in business • Executor may not want to run business • Successor not fully trained/mentored • May not be qualified – lack professional certification • Owner associated with Entity • Loss of owner results in loss of goodwill • Personal relationships with clients • Personalized service only owner provided

6. One-Way Cross-Purchase Buy-Sell Agreement An alternative strategy. The owner will have negotiated a sale to a selected buyer prior to death A sale is agreed to at a set price at a triggering event (death, retirement, disability, specified date, etc.) Entity redemption not an option—entity cannot exist without an owner/manager of operations.

7. One-Way Cross-Purchase Buy-Sell Agreement Pool ofPotential Buyers: Key Employee Competitor Relative Potential Buyer Friend/ Colleague Unrelated Third Party

8. One-Way Cross-Purchase Buy-Sell Agreement • The owner (or his/her estate) will sell to the specific buyer, and the buyer will purchase the business interest from the owner • An agreed upon price or formula to value the business • Specified list of assets and liabilities to be transferred • A means of funding, such as life insurance, is chosen so buyer is capable of making purchase Buy-Sell Agreement contracts vary in terms, but allcontain following mandatory provisions:

9. Funding the Agreement – Term vs. Perm Parties to agreement often want to fund with term insurance, due to lower premiums, but permanent insurance may be more appropriate because: • Triggering event for buyout often occurs for reason other thandeath (e.g. retirement, disability, specified date) • Buyer can use cash accumulation in a permanent policy to fund a lifetime buyout • Permanent policy with cash value build-up works better for a long held, well-established business • Length of agreement may extend beyond time that term isavailable (gets too costly after a certain age) • At time participants want to switch to permanent, insured may be in poor health or uninsurable.

10. Key Executive as Buyer – Executive Bonus Candidate to replace owner – Key Executive in Business • As salaried employee, may lack funds for buyout • Owner can implement Executive Bonus arrangement to fund policy • Premiums are paid through taxable bonus to executive • Employer receives a §162m deduction (as compensation) • Executive purchases life insurance policy • Executive is owner and beneficiary of policy • Employer may add “double bonus” to cover estimated income tax liability to Executive on both bonuses • Premiums are not tax deductible for Executive • With a Restricted Bonus, executive has limited access to cash value of policy based on certain events (e.g. disability of owner)

11. Executive Bonus: Here’s How it Works Bonus Payment: Employer makes taxable bonus payment to executive and receives corresponding income tax deduction.1 Executive reports bonus as additional income. Life Insurance Employer Life Insurance Purchase: Executive uses bonus payment (minus income taxes) to purchase life insurance policy. Accessing Benefits: Executive has access to policy’s cash value at predetermined time or specified event. Executive receives death benefit, used to fund buyout of owner’s business interest. Executive 1 Provided amount of bonus is reasonable and employer retains no ownership rights or beneficial interest in the policy.

12. Using an Escrowed Buy-Sell Arrangement Setting up the buy-sell agreement with an Escrow as intermediary can serve many purposes: • Ensures enforcement of the arrangement • Prevents likelihood of buyer unilaterally backing out of agreement after owner’s death, and keeping policy proceeds. • Custodian of life insurance policy • Ensures payment of premiums • Prevents access by creditors • Preserves integrity of policy (prevents policy withdrawals, which could cause lapse)

13. One-Way Cross-Purchase Buy-Sell:Here’s How it Works Example: • Felix owns cleaning service, sole proprietorship • At his death, company would liquidate • Goals: To ensure his wife and children are taken care of after his death with a lump sum or stream of income Felix’s Cleaning Service Felix, Sole Proprietor

14. How it Works Example – Felix’s Cleaning Service Example: • Oscar was once one of the worst employees • After many years, Oscar has shaped up and is the best, and manages all the other cleaners • Goals: Felix decides to choose Oscar to take over the business when he leaves. Oscar jumps at the chance. Oscar, Head Cleaner Key Employee

15. How it Works Diagram – Felix’s Cleaning Service I. During Felix’s Life: Sole Proprietorship (Cleaning Service) Sole Proprietor (Felix/Felix’s Estate) 2) Employee Bonus/Employer Deduction 1) Buy-Sell Agreement 3) Income Tax on Bonus 4) Premiums IRS Transamerica Policy (on Felix) Buyer (Oscar - Key Employee)

16. How it Works Diagram – Felix’s Cleaning Service Sole Proprietorship (Cleaning Service) Sole Proprietor (Felix/Felix’s Estate) II. At Felix’s Death: 8) Income Tax on IRD 7) Business Interest 6) Sale Proceeds 5) Death Benefit IRS Transamerica Policy Buyer (Oscar - Key Employee)

17. Tax Consequences If employee bonus used: Deduction allowed for business Income must be recognized by Key Employee/Buyer Generally, policy death benefit federal income tax-free Owner’s estate receives step-up in basis at death, so no capital gain in business likely to be realized Income in Respect of a Decedent (ex. notes, accounts receivable, commissions received after death, substantially appreciated inventory): No step-up in basis at death Subject to ordinary income tax If buyer predeceases owner, value of life insurance policy is included in buyer’s estate

18. Effect of Estate Basis Step-Up

19. Advantages • Known buyer at death or retirement • Plan for management of business at death or retirement • Sale proceeds a source of income for family • Pegged value of business Sole Owner • Offer to own business • Funding (life insurance) to pay purchase price • Basis in business interest equal to purchase price Key Executive/ Buyer

20. Transamerica Life Insurance Company, Transamerica Financial Life Insurance Company (collectively “Transamerica”), and their representatives do not give tax or legal advice. This material is provided for informational purposes only and should not be construed as tax or legal advice. You should rely solely upon your own independent advisors regarding your particular situation and the concepts presented here. Discussions of the various planning strategies and issues are based on our understanding of the applicable federal tax laws in effect at the time of presentation. However, tax laws are subject to interpretation and change, and there is no guarantee that the relevant tax authorities will accept Transamerica’s interpretations. Additionally, this material does not consider the impact of applicable state laws upon clients and prospects. Although care is taken in preparing this material and presenting it accurately, Transamerica disclaims any express or implied warranty as to the accuracy of any material contained herein and any liability with respect to it. This information is current as of April 2009. Transamerica Financial Life Insurance Company is authorized to conduct business in the state of New York. Transamerica Life Insurance Company is authorized to conduct business in all other states. OLA 1957 0509

21. Business Succession Planning for the Sole Owner One-Way Cross-Purchase Buy-Sell Agreements OLA 1957 0509