In this podcast you will learn about:

  • When you have business partners, why a buy-sell agreement is so important;
  • The role life insurance plays when funding a buy-sell agreement;
  • What happens when a business owner wants to pass their business to the next generation; and
  • How life insurance can be structured for a sole proprietor who doesn't have children or a spouse interested in running the business.

About the Guest

Carl Lutz is a wealth strategist at Lutz & Associates. Since 1999, Carl has served more than 400 families and business owners in the area of building and protecting wealth. Having owned a family business with his father for 16 years and employing more than 20 people, Carl has the ability to relate to the challenges that business owners face on a daily basis. Since he recognizes that the primary asset of your business is people, his primary focus is to help his clients protect their business and families from unforeseen life events such as lawsuits, sickness or injury, dying prematurely, a partner leaving the business or losing a key employee.


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Noah Rosenfarb: Hi! It’s Noah Rosenfarb here again in another of our series of podcasts on Exit Strategy. Today, we’ve got a great guest in Carl Lutz. He is an expert in buy-sell agreements and life insurance. I’m really excited to have him here because this area of buy-sell agreement is something that a lot of business owners hear about, but many fail to implement the plan. Carl is here with us today to share his knowledge.

Carl, let’s get right into it and tell me about buy-sell agreements in general. Define them for our audience and maybe just give them the broad overview.

Carl Lutz: Sure. First of all, thank you for having me. This is one of my favorite subjects and I’ll tell you why. I was in business with my father for 16 years and I have discovered that no matter what business you’re in that family dynamics around business planning and money and the buy-sell planning is really the same story whether you’re a real estate developer, an auto dealership, a restaurant owner, or what have you. This is a real fun subject for me and I appreciate you having me here.

A buy-sell agreement, I guess the easiest way to think about it is it’s like a prenup. I think most people are familiar with prenups. A prenup is something you sign before you get married basically, not everybody does, but often if you have any kind of significant wealth or asset you’re worried about that might get broken up in a divorce, you make an agreement in advance as to what happens to those assets before the event. A buy-sell agreement is very much like that. It’s an agreement between business partners that says here’s what’s going to happen to your business interest in the event of X. X is typically what they refer to as a triggering event.

A triggering event could be something like if your partner dies or somebody becomes disabled or if you’re a doctor’s practice and somebody loses their license or they’re being sued or they want to walk away. They walk in one day and say I’m out of here. If you have this agreement that you’ve written up in advance, it’s buy-sell agreement, which just simply means who’s going to buy and who’s going to sell and under what event will a buy or a sell occur.

Then, think about it, it’s really challenging to negotiate things at the time of crisis. Most of those things I just mentioned are times of crisis. That’s primarily what a buy-sell is. The other thing that covers often and it should is either a formula or a pegged value for that business interest, because the business interest of a closely held corporation is very different valuation than if you own the Apple stock. That’s pretty easy to determine its value, right? But stock of a closely held corporation could mean something different to everyone involved. From a surviving spouse, it means one thing. If I’m the guy buying it, it means another thing. Does that make sense, Noah?

Noah Rosenfarb: Yeah, that’s quite a great explanation. I think when I’ve spoken with owners around this topic, a lot of the resistance I get is "Who knows how much it should be? We’ll just deal with it when we get there." So, explain the importance of designing this buy-sell agreement upfront before there’s a problem, before there’s a crisis.

Carl Lutz: Okay. Well, let me say that part of the reason that people say that and they understand that it’s valuable, but they don’t take action is because they’re kind of afraid to address it. It’s a lot like people getting their wills. For whatever reason, like often a husband and a wife cannot agree upon guardianship of their children, so that prevents them from getting their estate planning documents in order and really when you make a decision not to do something, you are making a decision.

You're saying by not getting that agreement done, you're saying we’re going to let the chips fall as they may. That’s really risky business. The benefit of getting that done, I’m thinking of a client right now. These are two brothers, no problems at all. They get along great. They have a very nice business. They're both married. I think they’re in their third generation. Their grandfather started the business. They have very different job descriptions within the business. Their spouses have nothing to do with the business. I met them a few years ago and I really started working with one of the business owners and we were doing his individual planning which I strongly encouraged people do, you should do your individual planning. The proper order will be to get your own house in order and don't just do the business planning. It should all be done together.

Anyway, I asked them a question which is "What do you think your greatest concern is when it comes to your finances?" He said my 401k going up and down in value or something to that. He says, "What do you think?" I said the fact that you don’t have a buy-sell agreement. He says "Why?" I said, "Well you love your brother. There are no problems. You love your sister-in-law, but do you want to be partners with your sister-in-law. Does she understand this business?" I asked the other brother eventually, "Would you want your wife to be part of the business?" He said, "Absolutely not." I said, "How about the real estate?" Because a lot of business owners own the real estate in which they operate out of. I helped them to see that just because we transfer the business from one brother to the other doesn’t mean we have got to transfer the real estate. Your spouse can continue owning the real estate as long as we have proper agreements in place and let the family enjoy the growth of the value of the real estate as long as like I said, there are things in place, so they can’t evict the other brother. They saw the light and they said, "Yeah."

I think what was getting in their way was much what you said was evaluation. We used their accountant. We came up with the formula and they have a buy-sell agreement after 32 years. Very happy about it.

Noah Rosenfarb: That’s great. We all know that’s a good success story. One of other guests for podcasts had told the story about someone that didn’t implement the recommendation and unfortunately passed away and ended up with litigation. I think that’s a pretty common story. Do you have any stories like that where they didn’t implement and you’ve heard about the fallout?

Carl Lutz: I know of stories where people haven’t implemented and, yes, I’ve seen the fallout. They haven’t been clients of mine. What happens is the surviving spouse, if we’re talking about the event is due to death, they’re scared, because you got to understand they just lost the income from that business. What most business owners don’t take into consideration is the real value the business is providing to the family. They look at the paycheck whether it would be a draw or W2, but that’s typically only the tip of iceberg. It’s the health insurance and the automobiles and the trips. It’s a lifestyle that that business is providing for that family. Suddenly, that surviving spouse is going, "Oh my gosh, I just realized how my life is going to change." Of course, they want the value of that business to be a much higher number.

Now imagine, this is a car dealership and it’s 2008. We all know what happened in the economy in 2008 and 2009. I actually know. I am familiar with the story about people that didn’t implement. It’s not my story, but it was a car dealership. Everybody loved each other, wives, husbands, everybody. No buy-sell agreement. One of them died in 2009. In 2008, they came up with a fair price. 2009 came and 2010 and those surviving partners couldn't make those payments anymore, because we all know what happened in the auto industry.

Yet the widow demanded the payments and then did go to litigation and it was a total disaster.

Noah Rosenfarb: I guess that’s why your expertise in life insurance and buy-sell agreements go hand in hand. Describe a little bit about the role that life insurance plays when people want to fund the buy-sell agreement. How does that work in terms of who owns the insurance? What do people do?

Carl Lutz: If we go back to the client of the two brothers I was just telling you, they have a C-corporation. That’s how they operate. That’s for their operations. Then they have an LLC which holds their real estate which is another level of planning of separating the assets for better liability protection. Like I said, the LLC interest will pass to the spouse and things will go on, but the C-corporation value, when you lose a key player in an operation, so in this example, these guys each make about 200 grand a year and as I said earlier, they each have very different job descriptions and they contribute to the bottom line in a different way.

Here’s what happens. Let’s say their name is Carl and Noah. Carl passes away. Not only does Noah suffer because Carl is no longer making contribution to help to the bottom line of the business, but all of a sudden, Noah owes Carl’s wife a bunch of money, because the agreement says you owe my wife X amount of dollars, a million dollars, and if it’s a good agreement, it will say the terms. Let’s say 10% for 10 years. There are a couple of issues with that.

First of all, like I said, the key man just died, so who knows how that’s going to impact the bottom line of the operation. Who knows how that’s going to impact customer relations or employee relations depending on the person’s role? We’ve got a bottom line that’s uncertain at that point.

Now, we have a new debt. Noah has got this new payment that he didn’t have before. Now, my wife is dependent upon Noah’s success. How do we make all those problems go away and make it a lot easier for Noah and make it a lot easier for my wife? That is for Noah to own insurance on me. If you own insurance on me, not in the corporation, but outside the corporation, that’s what we call a cross purchase plan. I’ll tell you why there’s a benefit to that. So, Noah owns the policy. He has probably taken a bonus out of the corporation to help pay for that premium. He’s paying income tax on that bonus. However, when he gets the death benefits, it’s tax free and then he has an obligation. There’s buy-sell agreement that says you need to apply those death benefits to your obligation.

Now, my wife, because I died owning some of that, she got interest. She technically inherited it first. She has a step up in basis which means that when she sells it to Noah, there are no capital gains under current law. She inherited it. She sells it to my old partner, Noah. Noah writes her a check. She doesn’t owe any income taxes. Noah now has a beautiful new basis in the business, because let’s say it was a million dollars. He has got a basis of a million dollars at least on that 50% and it's a real clean transaction.

In addition to that, it might make sense for the C-corp to own some insurance and that would be key man protection. That’s to help absorb the shock absorber loss. They act as a shock absorber to the loss of all the other things I mentioned, key employee relations, client relations, who knows what. I have encouraged business owners to recognize themselves is that they are the greatest asset of their business. Their business probably doesn’t exist without that. Without them, they are going to suffer the greatest economic loss. You want to put the surviving partner in the best position to succeed. Does that answer your question?

Noah Rosenfarb: Yeah. I think you also addressed kind of the ownership. So, in the cross purchase agreement, each of the owners owns a slug of inherence on their partners. On the key man insurance, the company would own insurance on each of the key employees.

Carl Lutz: That’s correct. I was going to say there’s one other way to do it. It’s called the stock redemption plan where the corporation owns the insurance and a lot of business owners fall to that plan, because it just seems easier, but it creates different tax problems. That’s probably something you can speak to even better in a future call. To get the step up in basis and to grab all those other benefits, it’s typically better as a cross purchase, unless there are multiple partners, then it becomes a little bit of a challenge.

Noah Rosenfarb: Where else do you advise business owners to leverage the power of life insurance in their personal planning and in their business planning? Aside from these buy-sell agreements, where else are you commonly recommending a solution?

Carl Lutz: Two areas. One, I try to help the business owner. I do a lot of work with dairy farmers. Dairy farmers have a lot of net worth, but not a lot of cash flow typically. They’re typically asset rich and cash poor. There could be a scenario where the farmer has one child who’s going to come into the business and he has been grooming that person along and that child is now 30 years old or a young adult and we’re going to do estate planning and we’re going to find a way to get the business interest to that child. Let’s say that business interest is worth 5 million dollars. Then, he has got two children who are not involved in the farm. Well, that can become a problem, because if you don’t do proper planning and if you try to leave the value of the farm to all three siblings and then there’s one sibling that needs to buy the other two out, it typically doesn't work very well.

What we’ll do is use life insurance as an equalization tool. What we’ll do is we’ll talk about that fair is not always equal. Yeah sure, the farm is worth 5 million bucks, but that’s only if he sells it. Everybody starts to see that. What we’ll do is put a plan together where the life insurance might be the asset that goes to the non-business children. It typically takes care of the problem. Then, the surviving child doesn’t have to buy out the interest and yet the other children still receive an inheritance. It’s the simplest tool to use to get that done.

Noah Rosenfarb: How about for those business owners that maybe don’t have any partners, don’t have children or a spouse that are interested and capable of running the business? Where do you see life insurance for them?

Carl Lutz: I’m thinking of a really big client I just got off the phone a little while ago. He fits that description. His children aren’t interested in the business. His wife has nothing to do with the business and he’s a sole owner. So, we had a plan pretty much for liquidation. It happens to be an auto dealership. When you’re an auto dealer, you’ve got to have a contract. The brand or whoever it is has to agree to the person that’s going to be in the franchise, so we’ve got all sorts of complex issues there. When we did his planning, it was just simply about making his family whole and we said, what do you think the business is worth as a going entity? I think we came up with about 4 million dollars. What we did was we insured him for 4 million dollars. He is the owner. His wife is the beneficiary, and if she is able to sell the business, great. If she is not, she was made whole.

There’s a scenario where you’ll literally just going to say, we don’t know what’s going to happen with this business. We don’t have a ready buyer in place. I would say this too. Even if you had a business partner in this scenario as an example, one mistake I think business owners make is they replace the value of the business as the thing that’s going to replace their income.

Let me clarify. If I was with that sole business owner and I said to that business owner, listen. Pretend you’re a Kodak employee and you make 200 grand a year and you’re 45 years old, how much life insurance would we have and what is it that we would be insuring? The answer is we will be insuring your income, your economic value to your family. I try to get business owners whether they are an individual or have partners to insure they’re income with their family first and then insure the value of the business, but a lot of them get caught in the trap of using the value of the business to replace their income. I want them to recognize that you are then basically liquidating an asset prematurely. Does that make sense?

Noah Rosenfarb: I think even in evaluation, they say you have to take out the reasonable compensation for the owner before you value the company. You got to kind of insure both sides of it.

Carl Lutz: Correct.

Noah Rosenfarb: In talking about buy-sell agreements, you mentioned some other instances aside from death where you would want to define what would happen. Disability is another one that there is an insurance solution for. Do you use insurance solutions as they relate to disability in buy-sell agreement?

Carl Lutz: I do. Of course, it depends on their occupation. Most of the business owners I work with I call them blue collar millionaires. These are guys that are in there, getting their hands dirty, their involved in the business. A lot of times they are not insurable from a job class when it comes to disability. If it’s a professional firm, doctors, lawyers, and attorneys, absolutely, a disability buy out is what we call it. That would be one of the provisions. All the same issues exist except somebody hasn’t died, but it has all the same challenges. If somebody becomes disabled, then the earning and profitability of that company could be impacted. Relationships could be impacted, so on and so forth. If you can fund that obligation in advance with insurance, you're going to be much further ahead in trying to fund that out of cash flow.

Noah Rosenfarb: Some of the other issues that you raised in these buy-sell agreements that are insurable risks, the risks you wake up one morning and say, "I don’t want to do this anymore." Or someone gets your product and dies and the spouse sues you. How do you handle those within your area of expertise? Do you give advice on those aspects to your clients?

Carl Lutz: Yes. In a couple of ways. Another big one that we address or what we call a walk-away provision. So, I’m thinking of a family where it was just mom and dad. They had three children and believe it or not, they were bringing in their three in-laws, so we had six new people coming in to this business. A big part of the idea of transferring some ownership was a psychological move to really have the children feel like they had some ownership, but you can imagine, look at all the variables there as to what could wrong. You got that many new interested parties. What we did was we put a vesting schedule in. As the parents were gifting interests to the children and to their spouses, we put in a penalty that said just because this thing is worth 10,000 bucks, if you decide to do a walk-away, you only have a 20% vested interest. This way, we’re not putting mom and dad in a position to have to buy-back the business. You couldn’t make it a 0%. I don't think because that is sort of undoes the idea of having them feel a piece of ownership.

Walk-away is something that is fairly easily addressed. It’s easy to get everybody to agree because they understand. If he's the one walking away, I got to buy. Thinking that way, so they like the idea of an 80% hit, but they understand is that it impacts them as well. We really want to disincentivize people from doing that. That’s a steep example. A lot of times if it’s two people, you’re going to have a walk-away provision that only goes to age 65 or whatever, maybe we’ll put a 25% discount, like two brothers and a partners. We’re not going to penalize them to the point of no return, but that’s how we do that. We typically put a discount on the shares in the event of a walk-away.

Noah Rosenfarb: Then you had mentioned the story about those brothers where they have an LLC and a C-corp which is great planning. Do you see that as part of the protection against law suits? Are you doing some of that asset structuring?

Carl Lutz: Yeah, and that’s all part of it because really if you think about it, retirement planning, business succession is what we’re talking about, the succession that happens under different events and estate planning, they all kind of go hand in hand. It’s often hard to address one without the other. I think if you're doing that, that could be a mistake. It’s kind of like if you’re working with someone. Imagine you went to the doctor and you’re like, "My elbow hurts." You suddenly gave your prescription for the elbow. I think most doctors are going to want to find out what’s going on, what’s causing the pain, where is it coming from? Often, wherever the pain is showing up isn’t really the source of the pain. I think that’s true with planning as well. I don't know that you can just focus on buy-sell agreement by itself. If the business owners are stuck, they’re busy, if you want to get one thing done at a time, go for it. I would recommend that people create a context of holistic planning.

We're doing an estate plan now on a very large family and that’s what we're doing. We’re structuring. We’re not doing the actual entities, but in my recommendations, we’re isolating assets into LLCs, and putting buy-sell agreements together. We always try to separate operations from the real estate, especially in the agriculture world. Agriculture, I talk about dairy farmers earlier, but crop farming, the value of real estate is kind of off the roof. Some work with the family now. In 2003, it was worth 5 million. They are now worth 8 million. Most of that is in the value of real estate. We try to protect the value of that real estate by keeping it separate from all the equipment and creating different entities.

There’s another great story of the children that aren’t involved in that operation. It’s okay for them to share in the ownership of the real estate, because of course we’ve got agreements in place that protect the success of the owner. It’s not like the kid in California can force the sale of the real estate. There are things in place to protect that from happening, but you can see if 30 million of that 80 million is in real estate and we’re not burdening the second generation from buying that from mom and dad, but we are doing planning around the operations because we’ve got that in its own entity. You can see all the benefits you can pick up by separation. It’s just not loss or protection. It gives us more opportunities for planning.

Noah Rosenfarb: Carl, for all business owner and listeners out there, what are some parting words of advice that you might want to share with them that we haven’t already covered?

Carl Lutz: I would say that they should recognize the problems we’re talking about solving right now are problems that don’t exist yet. If you’re a business owner, you’re busy, you’ve got employees, you’re working in your business, you’re dealing with putting out fires on a daily basis, and you always have in the back of your mind, I’ll get to that other stuff. I’ll get to the estate plan. I’ll get to business succession planning. The reason I think you do that is because it doesn't appear to be a problem right now that you have to deal with, but I’m telling you if you don’t deal with it in advance, it’s going to be undone or it has the opportunity to undo everything you’re working for and that you need to dedicate some time to put aside to deal with these issues before they’re an issue.

Noah Rosenfarb: Good advice. I like to use the term it’s incredibly important, it’s just not urgent and I think for that reason people tend not to look at it until it’s urgent. Unfortunately, when it’s urgent, it is usually too late.

Carl Lutz: Exactly.

Noah Rosenfarb: I totally agree with you.

Carl, if our listeners wanted to get in touch for some advice on crafting a buy-sell agreement or putting life insurance in place for their family, how would they get in touch with you?

Carl Lutz: A couple of ways. They can visit my website which is www.Lutzandassociates.net or they can feel free to give me a call. I’m in upstate New York at 585-264-1111. That would probably be the two best ways.

Noah Rosenfarb: Great! Well, Carl Lutz, an expert in buy -sell agreements and life insurance, thank you so much for joining us today and to all our listeners, don’t forget when you download us on iTunes, please put some feedback down there for us or on www.Divestopedia.com. Feel free to leave some comments. We’d love to hear from you.

Carl, thanks once again. To all our listeners, thanks for joining us.

Carl Lutz: Take care.