Funding Your Buy-Sell Agreement

There are two major strategies that can be used for funding a buy-sell agreement. One strategy is to fund the buy-sell agreement with insurance policies. The second strategy is to fund the buy-sell agreement with tools other than insurance. Each of these funding strategies has merits and drawbacks. Some methods are more convenient for the buyer, while others may be better for the seller. The specific type of buy-sell agreement is an important consideration in the funding decision. Funding can be accomplished using more than one method. Whatever funding method (or combination) is chosen should be specified in the buy-sell agreement.

Insured funding options
Under the insured funding options, the two major types of insurance are:

  • Life insurance
  • Disability insurance

Noninsured funding options

The methods of funding a buy-sell agreement that do not use insurance policies include:

  • Cash
  • Borrowings
  • Installment payments
  • Private annuity
  • Stock redemption
  • Sale-leaseback
  • Appreciated property bailout
  • Deferred compensation

Why worry about funding at all?
It may be tempting to ignore funding when your buy-sell agreement is being established, because the triggering events are perceived as being far off in the future. Without advance funding arrangements, there is a risk that the sale of your interest could be delayed, or even worse, you or your estate may never get the money. This is especially critical if the reason you set up your buy-sell agreement was to provide your estate with liquidity. The use of prearranged funding can help to eliminate any potential uncertainty that could come up at the time of the actual transaction.

Factors in the funding decision
Factors that will generally influence the choice of funding method include business structure, size, and tax bracket; number of owners, their ages, tax brackets, and ownership percentages; levels of cash or credit available to the business or the owners; and type of buy-sell agreement. Depending upon the specific details, there might be just one funding method that is appropriate, or there may be several funding methods that could be used. Important considerations in choosing a funding method for the buy-sell agreement may include:

Cost of implementation
These would include interest costs, opportunity costs, and any legal and setup fees. The general interest rate levels affect the cost and attractiveness of borrowing at any point in time. Cash that is being held in a sinking fund may cause the company to miss out on a more profitable business investment or expansion opportunity. Legal and setup fees can arise from the use of trustees or special funding accounts. Some funding methods require an immediate outlay of cash, such as an initial deposit or premium payment, while others do not need a payment until the time of the transaction.

Time frame for funding
The time frame is the big unknown factor under a buy-sell agreement. There could be many years to accumulate the money for the purchase of a business interest, or it could be needed next week. If retirement is a triggering event, the time frame might be somewhat more predictable, but a death or disability can happen at almost any time.

Tax consequences
Generally, when a company buys back the stock of an individual shareholder, the payment is not tax deductible. It is possible, however, to structure the buy-sell funding so that some (or all) of the payments for a shareholder's stock are tax deductible. This may be possible when borrowings, deferred compensation, or sale-leasebacks are used. From the seller's point of view, installment payments or private annuities may allow gain from the sale of the business interest to be spread out over a period of time. Some methods might lead to unintended estate or gift tax consequences. In the case of a family corporation, the seller could have difficulty receiving favorable tax treatment for the sale of stock to the corporation itself.

If the business is a corporation, both the business entity and the individual owners may be subject to tax on corporate profits--the corporation when the profits are earned, and the shareholders if the profits are distributed as dividends. When the owners (or an outside individual) are in a lower tax bracket than the business itself, it may make sense for the individuals to buy the business interest. Sometimes, it is less expensive for the business to pay for the purchase of a business interest. The difference in tax rates between the business and the owners should be considered when deciding on the form of buy-sell agreement and the funding method. When a company attempts to accumulate cash for a buy-sell transaction before a shareholder has died, it could be faced with the accumulated earnings tax. If life insurance is used, the company could be exposed to the alternative minimum tax if the proceeds are paid to the company.

Risk of failure of funding method
Ideally, parties to the buy-sell agreement want to minimize the risk that the funding method will fail to provide the cash when needed. Some funding methods, such as cash reserves, or the cash value buildup in a life insurance policy, may be subject to claims from creditors and therefore may not be available to fund the buy-sell agreement at the appropriate time.

Disparity in ages, ownership, health, or income of owners
Wide differences in the age, ownership levels, health, or income of the owners can affect the choice of funding. Often, the owner with the largest share is also the oldest. In a cross purchase, the younger owners, with presumably lower incomes, are purchasing a larger interest and must come up with more money to fulfill their obligations under the agreement. An older owner in poor health may be more difficult to insure (or be uninsurable) and could cause a triggering event sooner than a younger owner. See Alternatives for the Uninsurable for more information.

When should funding be established?
Some funding methods require action at the time of execution of the buy-sell agreement. In all cases, it is better if funding is established immediately. The value of the business interests and the corresponding liability of the buyer could increase over time due to real growth and inflation. Full funding from the start can help your plan to keep up with inflation and growth. You should periodically review the buy-sell agreement to determine whether the funding method is keeping pace with the value of the business interest.

How much funding
Ideally, the buy-sell agreement should be fully funded from the beginning. In other words, the full purchase price should be covered under the funding arrangement. But remember, even partial funding is better than no funding. If it is impossible to fully fund the entire value of a shareholder's interest, you can combine multiple methods, such as a cash down payment with borrowings or installment payments to cover the balance. You can also combine the use of insurance with noninsurance methods.

The consequences of not funding the agreement
Let's say you have drafted the greatest buy-sell agreement in the business world. Business is a little slow right now, though, so you and your co-owners decide to wait a little while to fund the agreement. Some years pass, and business improves; in fact, it is so good that you and your co-owners do not have time for much else beside filling the tidal wave of orders that keeps pouring in. You are so busy and focused on the incredible pace of your business that you forget your own name, never mind the buy-sell funding you put off. In all this excitement, you die. Your family turns to the buyer under your buy-sell agreement, expecting a quick sale of your business interest so that your estate expenses can be settled. But guess what? There isn't any money for the purchase of your interest, because the funding was not established. Your buyer has no money, so neither does your family. Your family can take the buyer to court to enforce the agreement, but this could take a lot of time, and your estate taxes are due soon. And the whole situation could have been avoided by setting up the funding at the same time as the agreement.

This article was provided by Forefield and distributed by Lawrence Sprung.

Tax Planning for Income

What is tax planning for income?
Tax planning for income usually involves strategies for minimizing your taxable income. In particular, the timing and the method by which your income is reported become paramount. Effective planning begins with an understanding of the various types of income. Next, you'll want to consider tools for creating tax-free income, methods of sheltering earned income from taxes, strategies to defer taxes (and other tax-advantaged strategies), and vehicles for shifting income and tax. For older taxpayers, it's also useful to know how to minimize taxation of your Social Security benefits.

Why is it important for you to understand the concept of income?
As a general rule, you are required to pay tax on your income from whatever source derived, unless a statutory exception applies. Therefore, it's important for you to know which items are included and excluded from the IRS's definition of gross income. Additionally, income can be taxed at different rates, depending on whether the income is ordinary or derived from the sale or exchange of certain classes of property held for certain minimum time periods. Because losses can sometimes be used to offset income, it's also important to understand the concept of active versus passive income.

Why is it important to know how to generate tax-free income?
Although income is usually taxable, there are a number of vehicles that can produce tax-free or nontaxable income. You may be able to enjoy some portion of your income, tax free, by switching some of your investment money to these vehicles. Several useful vehicles exist, including Roth IRAs, tax-exempt bonds, and qualified small business stock.

How can you shelter earned income from taxes?
Sheltering your earned income involves employing one or more tools to generate losses, deductions or credits that will reduce the current federal tax burden on your earned income. Typically, your desired result is income deferral. Several methods exist to shelter earned income from taxes, including traditional deductible IRAs and employer-sponsored retirement plans.

Why should you be aware of strategies to defer taxes?
There are several reasons why deferring the taxation of income is generally desirable. First, deferring taxes will provide you with more money right now to fund various financial plans. Moreover, certain qualified retirement plans allow you not only to defer some of your current taxable income, but also let your retirement savings grow tax-free until a distribution is taken.
As a general rule, when tax rates are stable, it's wise for you to defer the recognition of as much income as possible to a later year and accelerate deductions. This will allow you to minimize your current income tax liability. As a consequence, you will be able to invest money that would otherwise have been used to pay income taxes, keeping that money working for you. When you eventually recognize the income, it's possible that you'll be in a lower tax bracket.

What are some other tax-advantaged strategies?
Many other tax-advantaged strategies exist. For instance, you should be aware of tax shelters and tools for creating passive income in order to take advantage of passive losses. Additional strategies that may help you reduce your overall income tax burden include taking advantage of the tax benefits of generating capital gains, investing in real estate, receiving annuitized payments, and engaging in year-end tax planning.

How can you shift income and tax to others?
Income shifting refers to dividing income among two or more taxpayers in a way that lowers overall taxes. Typically, income is shifted from higher bracket taxpayers to lower ones. If you're interested in income shifting, you should be aware of a number of topics, including the kiddie tax, the tax treatment of below-market and interest-free loans, and the benefits of making gifts of income producing property and employing family members.

What about Social Security benefits?
If you're an older taxpayer, you should probably be concerned with minimizing the taxation of your Social Security retirement benefits. Certain techniques exist to limit the taxation of such benefits, including filing your income tax return jointly and employing tools to reduce your modified adjusted gross income.

This article was provided by Forefield and distributed by Lawrence Sprung.

Qualifying Donations for Haitian Relief Efforts May Be Deducted on 2009 Returns

On January 22, 2010, the President signed into law HR 4462 (Public Law No: 111-126), establishing special rules that apply to charitable donations made for Haitian relief efforts.
An individual who makes a qualified charitable contribution after January 11, 2010 and before March 1, 2010 for relief efforts associated with the January 12, 2010 earthquake in Haiti can treat the deduction as if it were made on December 31, 2009. As a result, individuals who itemize their deductions on Form 1040, Schedule A, can elect to claim the deduction for their Haitian relief contribution on their 2009 federal income tax return. To qualify, the contribution must be made in cash.

Except for the ability to treat the contribution as if it were made in 2009, normal rules and limitations associated with charitable deductions apply. It's important to note that, to qualify for a deduction, donations must be made to a domestic charitable organization.

The legislation also specifies that a telephone bill showing the name of the charitable organization, and the date and amount of the contribution, will satisfy the charitable deduction recordkeeping requirements. This provision was added to facilitate charitable donations made via text messages.

Required Minimum Distributions 2010

If you are turning 70½ in 2010, you will need to take a Required Minimum Distribution (RMD) from your Individual Retirement Account (IRA). Pursuant to IRS Regulations all RMDs must be withdrawn by December 31 each year. However, since this is the first year you must take an RMD, you may defer the 2010 distribution until April 1, 2011. Failure to withdraw the RMD by the required deadline may result in a 50% penalty on the amount not distributed as required by the applicable IRS Regulations. If you choose to defer your 2010 RMD until April 1, 2011, your 2011 annual RMD still must be withdrawn by December 31, 2011.

If you are already 70½, you will need to satisfy an RMD from your IRA for 2010. Your RMD must be withdrawn prior to December 31, 2010. Again, failure to withdraw the RMD by the required deadline may result in a 50% penalty on the amount not distributed as required by law. As you may know, there was a one-year suspension for RMDs in 2009. Notwithstanding, your 2010 RMD must be withdrawn by December 31, 2010, regardless of whether you took advantage of the 2009 suspension. You may not defer your 2010 RMD until April 1, 2011.

Can You Afford to Have One Spouse Stay at Home?

For many families, this is an important question. Unfortunately, most dual income couples feel that both of them have to work in order to meet their expenses and maintain their lifestyle. If you evaluate your situation financially--factoring in the cost of working and the amount of taxes that you pay while both of you are working--you may find that you have a choice. One of you may be able to stay at home without seriously affecting your cash flow. This evaluation will at least enable you to make a more informed decision.

When one spouse stays at home, you will not have to incur several work-related expenses, especially if you have young children and are paying for child care. Most people are aware of child-care expenses because they are so obvious, but you need to take into account many other hidden expenses when you consider staying home. In many cases, not only do you save money by not incurring those expenses, but you may be able to save a great deal of money by making some small changes in your lifestyle. Here is what you need to consider:

  • Impact of the loss of second income
  • Cost of earning the second income
  • Hidden benefits
  • Long-term cost of not working
  • Lifestyle changes

Impact of the loss of second income
Frequently, the real impact of the second income is not as much as the income itself. In fact, it can be much less. It is easy to think that if you are making $70,000 a year, your loss would be $70,000. However, if you calculate the taxes, the extra cost of working, and other expenses, the real impact may be far less, depending upon where and how you live.

Cost of earning the second income
Here is a list of some typical expenses that you need to consider before making that decision. Look at your spending diary and identify how many expenses are related to both of you working. Make a list of how much you can save by not incurring those expenses.

Child care
For most working couples with young children, child care is the expense with the most impact on your decision. Depending upon how young your children are, the kind of child-care arrangement you prefer, and the number of children, the cost of child care will vary. When you calculate child-care expenses, make sure that you add related expenses, such as driving to and from the child-care center or any payroll taxes that you may be paying for your nanny.

The reduced commuting expenses also add up, not only in terms of gasoline and oil changes, but also wear and tear on your car and auto insurance.

Lunches out
When you are working outside the home, the seemingly small expense of lunches adds up. When considering whether you or your spouse should stay home, you should take into account the amount spent on office lunches.

Depending upon where you both work, you may be spending a sizable portion of your income to buy work clothes. When one of you stops working, you will not be spending this money on clothes.

Dry cleaning
The same holds true for your dry cleaning expenses. Add them up to find out how much you would save if dry cleaning became unnecessary for one of you.

Take-out dinners
With two of you working, you are probably spending a sizable amount of money on take-out dinners. If you are able to have your dinners at home, you reduce the need for expensive take-out meals. You may also save on groceries, since you will have more time to shop carefully, and may find many items on sale.

Housecleaning services
When both of you work, you may be paying to have your house cleaned. Add up those expenses.

Hidden benefits
There may be some hidden savings when you switch from a two-income to a one-income household. For example, you may be able to save on taxes. Often, your joint income puts you into a higher tax bracket and you wind up paying a good portion of one spouse's income on taxes. If you are filing a joint return, calculate the impact of the second income on your taxes.

Long-term cost of not working
Although the picture in the short-term may look promising for one spouse to stay at home, you need to consider some long-term implications of that decision.

Consider the long-term effect on your 401(k) plan. If you or your spouse remain in the workforce, 401(k) plans not only give you an immediate tax break, but also grow to make a larger retirement nest egg. Your 401(k) is funded more when you are working because you are contributing (and your employer may also make contributions).

Consider when, if at all, you or your spouse is planning to reenter the workforce and the effect on future earnings. When one of you reenters the workforce, your earning power is likely to be diminished. Some individuals who reenter the workforce find that they are not getting paid their former salary while doing a similar job. Also, you may have to climb the career ladder once again since there may not be the opportunity to start where you left off.

Remember that now you are more exposed to the risks of the economy because you are dependent on one income. You are more vulnerable to economic downturns and company downsizing. So, if the working spouse loses a job, it will have a more devastating effect on the family's finances. Keep in mind that as your children grow, your child-care expenses--one of the biggest expenses in a young family's budget--will decrease considerably. As a result, you will save less from having one of you stay home.

Lifestyle changes
When one spouse stays home, you may need to make some lifestyle changes. In fact, making some changes in your present lifestyle might allow one of you to stay home. Here is how you can do it.

Make two lists: need list and want list

In your need list, include all the bills that you have to pay, whether you stay home or work outside. In your want list, include entertainment, travel, music and dance lessons, books, toys, and gifts. For many, the need list is probably all you can handle with one income. Don't panic. You can take steps to have at least some items from your want list.

Reduce expenses
You can make both big and small changes that will reduce your expenses. For more information and specific ideas, see How to Cut Costs.

Remember that little things add up

By making small changes, such as turning off lights when not needed or drying clothes on racks instead of using the dryer, you not only save money, but also instill in your children the value of such things.

Make things instead of buying them

Frequently, your creativity gets a big boost when you have a little more time to yourself. You can save a considerable amount of money by making small things such as birthday cards and holiday gifts. The added advantage can be the personalized attention given to each item, and the feeling of joy when you have created something yourself.

Find alternatives

If you work out at a health club, find out if you can join a nearby YMCA or a less expensive health club instead. Instead of renting a hotel room at a fancy resort, find out if you can rent a cabin in a national park.

Find out if you can make money working at home

You may not realize that you can also make money by staying home. Find alternative employment such as a part-time, evening, temporary, or a work-at-home job to fill the shortage.

Turn your hobby into a part-time business

If you like to write, find out if you can write for your local newspaper. This will not only give you extra income, but also some recognition, and may be a way to voice your opinions. For other ideas, see How to Increase Cash Flow.

Plan ahead

Do not quit your job without planning. If you plan ahead, you can pay off a loan to save monthly installments, secure a part-time or at-home job, or start implementing other lifestyle changes to reduce the impact when your second income stops.

This article was provided by Forefield and distributed by Lawrence Sprung.

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