Most small businesses don’t last after the first generation of owners die. If you’re starting a family business, or if you have a partner and want the business to be able to continue after you or your partner die, purchasing life insurance can be extremely helpful.

For example, let’s say you and two partners own a business and each of you has a family. Now let’s say one of the partners dies unexpectedly, and the other two partners want to purchase the deceased partner’s interest in the business from his or her spouse. Having a life insurance policy on each partner worth the value of each partner’s share in the business will help surviving partners purchase the deceased partner’s share without undue financial hardship on the business or the surviving partners’ personal finances.

Here’s another example of how life insurance can be beneficial to small businesses. Let’s say your small business has a key employee who performs tasks that require unique training or experience. Now let’s say that employee dies. A life insurance policy on that employee can help provide your business with the money it needs to stay afloat if the employee dies and projects he or she were working on must be outsourced to other businesses and while you search for a replacement.

Prior to purchasing a life insurance policy on proprietors, partners or key employees, it is important to value the worth of your business.

Valuing your business

Business valuations are made based on the current value of cash flows the business is expected to have in the future. Regardless of what method you use to value your business, the basic premise remains your business’ ability to generate cash flow.

Two of the most commonly used business valuation models are the cash flow multiple method and the price earnings multiple method.

The Cash Flow Multiple Method works well for most small businesses and is nicknamed the Main Street approach. In the cash flow multiple method, a multiple is applied to the expected adjusted cash flow stream of a company. The multiple usually ranges between 3 and 6, and is usually determined by an evaluation of a company’s potential for risk and growth.

Historical cash flow data is usually the basis of calculating the business’ future cash flow stream. For example, if your business has had EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of about $1 million, and a multiple of 3 is applied, the business’ value would be $3 million.

The Price Earnings Multiple Method is better suited for larger businesses, such as publicly traded companies. In this method, the business valuation is determined by taking the net after tax profit of a business and applying a market driven factor as a multiplier. For example, a numerical value may be assigned to high growth rates, financial resources, strong market position, etc. As a result, most businesses using this method may have multiples of 10 or higher.

Once you have a good idea how much your business is worth, or is likely to be worth, you should purchase a life insurance policy for you and your partners eqivalent to each partners’ share of the value. For life insurance policies for valued employees, you and your financial advisor may want to use a policy based off the business’ value or another calculation regarding that employee’s contribution to the business.

The benefit of purchasing life insurance policies for partners is that it can head off the succession squabbles that often kill small businesses. By immediately having the wherewithal to buy out a partner’s share in the business, you can avoid costly court wrangles with heirs that can be harmful to your personal finances or to the ongoing operation of your business.

Even single proprietor businesses can benefit from a life insurance policy for the proprietor, as it can provide some financial cushion for your heirs as they learn how to run the business or allow heirs who are better suited to run the business to buy out the interest of other heirs.

Succession planning isn’t something you should put off, as the unexpected can happen at any time. To get a better idea of the options most appropriate for your company, contact a financial services professional and a life insurance agent or broker.

According to the Small Business Administration, only about a third of small businesses survive the passing of critical individuals, such as owners or founders. Only 15 percent of family businesses survive to a third generation of management.

An expert study recently found that less than one fifth of family business owners don’t have any estate planning other than a will and less than half have written strategic plans covering what happens to the business in the event of their death.

Succession planning helps smooth the obstacles to the continued operation of your business in the event of your or a partner’s passing. By having a succession plan in place, issues such as tax liabilities, transfer of shares or ownership, and leadership issues will already be settled in the event of your or a partner’s death. Having these issues settled can help stave off litigation or tax penalties that can be the death knell of a small business.

Succession planning is essentially the development of a plan that spells out how the transfer of ownership of a business will occur, determining who the new management will be and planning for issues related to tax liability and continued operations of the business. Small business owners should begin succession planning while they’re still in good health, to give them time to take care of financial issues that may arise after their death and time to mentor and train the next generation of leadership for their company. Changes to the succession plan can be made later as circumstances arise, such as the departure of a partner from the business or if a successor is found to be unsuited or unwilling to take up the reins after you are gone.

Identifying a Successor

The first thing you should do when preparing a succession plan is to determine who your successor or successors will be. Do you intend to pass your share to your children or spouse or let a partner buy out or inherit your share? If you plan to split up your share among your children, will they have equal control of the business after you’re gone or will one be the senior partner? Resolving these issues is important, and with the help of an attorney or estate planner you can determine these issues and have them put in writing. Getting this settled now can prevent unnecessary and destructive fights over control of the business or uncertainty concerning who’s entitled to what after your passing.

Tax liability

Tax liabilities that result from the passing of a business from one owner to the next can have significant costs, and in some cases can sink your business. Finding tax efficient means of transferring your business to your successors can help preserve the financial integrity of the company you’ve worked so hard to build.

While many estates aren’t substantial enough to incur estate taxes, consider all the assets of your small business. While your small business may not have millions in cash, the land, equipment and other assets of the business may add up to enough to incur estate taxes. That’s why having your business valued and hiring an estate planner to help you plan the transfer of your estate is so important. Here’s a few ways an estate planner can help you stave off estate taxes.

Wills and Trusts

For starters, it’s very important to have a will. Your will lays out how your estate, including your business will be divided upon your death. If you don’t have a will, the state could end up making these decisions.

A living trust is an agreement between you and a trustee created for the benefit of your successors. The agreement is established while you are still alive and allows you to maintain the assets for your use until your passing and designates how they will be transferred if you die. This document is helpful for business owners who may become incapacitated by illness or injury as at protects their assets while they are alive and handles their transference after death.

A marital deduction trust provides for your spouse after your death. Under the trust, your property remains under your control until your death, when it is transferred to your spouse. These assets are not subject to taxation when you die, but rather when your spouse dies. Also, you get to designate what happens to the remaining property when your spouse dies, its disposition is not governed by your spouse’s will.

You may also use the installment payment tax deferral tool, which allows your successors to make payments on the estate tax for your estate or business. Under this plan, no estate tax is collected for five years, but afterward they pay the tax, with interest, in installments over the next 10 years.

The catch is that your business must be active, and your interest in the business must be equal to 35 percent or more of your total estate.

Estate Freeze

The estate freeze is a recapitalization technique that lets business owners cut their estate taxes by setting the value of their business at a set point in time. By freezing the value of the business, higher estate taxes are avoided because the value of the business will not increase over time for estate tax purposes. You can create an estate freeze by creating preferred stock in your business that allows you to keep operating control of your business while transferring common stock in the business to your successors. Your preferred stock will not appreciate in value, but when it is transferred to your successors, they will have to pay gift taxes, however, their overall tax burden should be reduced by this tactic.

Tax Exclusion Techniques

There are a variety of tax exclusion techniques your estate planner can also use to limit your tax liability.

For example, the unified credit/exemption equivalent trust can be established by your will or living trust for the benefit of your successor. The trust is funded by the full amount of property you’re permitted to leave to heirs other than your spouse estate tax-free. This amount usually is about $600,000.

A dynastic trust can be used to benefit grandchildren, allow you to establish a trust in your will or living trust that is funded by the maximum amount of property you can bequest to third generation beneficiaries without incurring estate tax, typically $1 million.

You can use the annual exclusion gift to transfer your business to your successors a piece at a time. You can transfer gifts of cash or property up to $10,000 per recipient each year free of federal taxes.

These are just a few of the estate-planning tools you can use in your succession plan to minimize your estate tax liability. Consulting with an estate planner is recommended to help you find the estate planning tools most appropriate for passing your estate to your successors while incurring the least amount of estate tax possible.

If You Have Partners

If you have a partner in your business, succession planning typically takes on a whole new dimension as there are extra parties with an interest in your business. In many succession plans in partnership businesses, the partners have life insurance policies on one another that allow the other partner to buy out the deceased partner’s share in the event of his or her death. In some partnerships, a partner may want his or her spouse or children to take his or her place after the partner dies. Having issues concerning what happens in the event of a partner’s death is very important for partnership businesses, as leaving matters in limbo may result in the surviving partner scrambling to raise cash in the event of an unexpected death, or saddled with an inexperienced or disagreeable new partner.

Frequent Review

Once you have your succession plan in place, review it every few years to ensure that changes to the tax code won’t cause problems in the event of you or a partner’s death, that your designated successor is still who you want to take your place and that any life insurance policies purchased to buy out partners’ shares still reflect the value of those shares.