The Smith’s (Charlie and Mary) have a built a fine business. According to their accountants, it is worth about $7 million. Now in their early 60s, they want to reduce their commitment to it and have their son Charlie Jr, take it over. He has worked in the business for the past seven years and neither of the other children are interested in doing so. Charlie and Mary go through the steps. Freeze, holding company, isolate operating company, family trust, strip out some assets with an Individual Pension Plan, build some middle management into the plan to sustain senior’s special technical skills that go away when parents leave, and some agreements to formalize it all. Most importantly they create a 5-year “engagement period” wherein Junior will gradually acquire executive decision making duties and skills, control over most decisions, a full knowledge of finance, important contacts like bankers and professional advisors, and the nuance of customers and key suppliers. He and the parents will develop a joint vision of the long future for the business.
Senior sees the frozen shares to be their legacy for their children. He expects the dividends on the frozen shares and the pension plan to be safe and secure income for the rest of his and Mary’s life. They have provided a joint life, second to die, life insurance policy so that the tax and cost burden in the estate will be no more than inconvenient. They intend to leave most of their other assets in trust for grandchildren.
What could go wrong?
Not a lot usually. Junior learns the business, Mom and Dad are around and available for advice on situations that make no sense to him. (Experience has some value.) The business prospers and eventually the family wealth is distributed and enriches the younger generations.
In the real world, sometimes Junior could make serious mistakes and the business could be imperiled. That seldom happens instantly and those frozen shares will have voting rights if needed. A turnaround or sale could solve the problem for the parents and the family. Inconvenient but not tragic.
There is one mistake that the parents made though.
Eight years later, Mom and Dad have been out of the day to day for several years. The business is growing and taking on new employees, product lines and debt to finance real estate and equipment. Junior and the head of marketing die together in a car crash.
The rule of thumb is that a complicated business is worth about half if you cannot supply a two-year period of management transition. How safe are the frozen shares now? How secure the income?
Cheap and easy solution. Life insurance on Junior. A lot of it. At least the value of the frozen shares. Key person insurance on the other executives would be sound planning too.
In my career, I have delivered insurance checks on the death of the successor twice. In neither case would the parent have been easily able to take over the business and run it. In both cases, the business was sold at a discount. In neither case was the family wealth and income harmed.
The insurance need not be of a form that has a high premium. The choice should include the right to convert later to a plan that suits Junior’s evolving estate plan.
Life insurance is a tool that minimizes financial risk to individuals. On a 35-year old male non-smoker, $7,000,000 of term coverage from a large insurer with good plans to convert to when the time comes, costs less than $4,000 per year. Females would be less. Why risk a life time of work for .06% of the value covered.
No matter how unlikely, pay attention to what the risk means. Improbable but huge risk, small premium. Penny wise / pound foolish is too polite. This oversight is just plain foolish.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. email@example.com 866-285-7772