Business Continuation Insurance

Smashwords Edition

BUSINESS CONTINUATION INSURANCE

2nd Edition

CAL-STATE EXAMS

5059 Newport Avenue, #209

San Diego, CA 92107

Telephone: (619) 222-2425

Copyright © 2010-1991 REAL ESTATE LICENSE SERVICES, INC. Copyright registered. All rights reserved. No part of this material may be reprinted, reproduced, transmitted, stored in a retrieval system, placed in a computer or on the Internet, or otherwise utilized, in any form or by any means electronic or mechanical, including photocopying or recording, now existing or hereinafter invented, nor may any part of this course be used for teaching without permission from the copyright holder. CAL-STATE EXAMS is a division of REAL ESTATE LICENSE SERVICES, INC., holder of the registered copyright.

TABLE OF CONTENTS

PART ONE – PROPRIETORSHIPS

General Information About Sole Proprietorships

Definitions - Property Rights and Liabilities - Advantages and Disadvantages

Termination of a Sole Proprietorship

Causes of Termination - Economic Effects of Termination

Continuation of the Business Without Proper Authority

Problems Associated with the Continuation of the Business Without Proper Authority

Continuation Plans Made by the Proprietor Acting Alone

Legality - Will Provisions - Disadvantages - Hazards - Specific Bequests - Business Property

Agreements Between the Proprietor and Others for Continuation of the Business

Types of Agreements - Desirability - Financing the Agreement

Specific Benefits of the Insured Buy-Sell Agreement

Benefit to Employees - Benefit to the Estate and Heirs - Benefit to the Proprietor

Contents of the Buy-Sell Agreement with Life Insurance

Drawing up the Agreement - Similar Patterns - Contents of the Agreement

PART TWO – PARTNERSHIPS

General Information About Partnerships

Definitions - Formation - Types

Property Rights and Liabilities in a Partnership

Ownership of Assets - Partnership Interest - Management Rights - Role of the Partners - Corporate Property Compared - Liabilities

Dissolution of a Partnership

Definitions - Reasons for Dissolution - Effects of Dissolution

Winding up and Termination of the Partnership on Death of a Partner

Role of Liquidating Trustee Economic Effects

Alternatives to Liquidation Improvised After a Partner's Death

Problems - Heirs as Partners - Drawbacks - Obstacles

Alternatives to Liquidation Set Up Prior to a Partner's Death

One Partner Acting Alone - Partners Acting Together - Example of Agreement - Court Validity - Survivorship Agreements - Financing

The Insured Buy-Sell Agreement – General Considerations

Life Insurance - Specific Performance

Specific Benefits of the Buy-Sell Agreement with Life Insurance

Benefit to Surviving Partners - Benefit to the Estate and Heirs - Benefit During Partners' Lifetime

Selecting the Type of Agreement

Types - Determination Factors

Contents of the Buy-Sell Agreement with Life Insurance

Drawing up the Agreement - Essential Elements - Financing with Life Insurance - Other Provisions

PART THREE – CORPORATIONS

General Information About Corporations

Definitions - Formation - Types

The Powers and Management of a Corporation

General Powers - Acquisition of Stock - Management Powers

Property Rights and Liabilities in a Corporation

Corporate Assets - Stockholder Interest - Corporate Liability

Characteristics of a Corporation Summarized

Primary Characteristics - Peculiar Characteristics

The Effect of the Death of a Close Corporation Stockholder

Sole Stockholder - Majority Stockholder - Minority Stockholder - Equal Stockholder

Plans Set Up by Stockholders Prior to a Death

First Offer Arrangements - Option Arrangements - Most Common Arrangement

The Insured Buy-Sell Agreement – General Considerations

Life Insurance - Types of Agreements - Determination Factors - Legality - Enforceability

Contents of the Insured Stock Buy-Sell Agreement

Drawing up the Agreement - Similar Patterns - Principle Provisions

Insurance Beneficiary Arrangements

Common Arrangements Available

CHAPTER QUIZZES

PART ONE – PROPRIETORSHIPS

General Information About Sole Proprietorships

What is a sole proprietorship?

A sole proprietorship is a business or professional enterprise owned and managed by one individual. A sole proprietorship business can be characterized as (a) A business enterprise owned entirely by one person in his individual capacity, as distinguished from ownership by a partnership or by a corporation; and (b) Customarily conducted by the owner (the sole proprietor), its business being transacted by him alone, or with the assistance of any agents or employees that he may hire.

How are sole proprietorships formed?

A sole proprietorship is created simply by the bringing together of those components necessary to carry on the particular enterprise and then opening shop. It is thus distinguished from the creation of a partnership, brought about by the voluntary agreement of the members, or the creation by law of a corporation upon completion of the necessary legal steps and the granting of the corporate charter by the appropriate state or federal government.

What are property rights in a sole proprietorship?

Before he opened his drugstore, Joe Doe owned various kinds of property. These he could keep, use, destroy, otherwise dispose of as he chose, subject only to the general laws restricting uses of property that would encroach upon the rights of others. Happily, among these items was a sturdy bank account, part of which he has now expended in the purchase of store fixtures, stocks of merchandise, and other needed business property: the property for his sole proprietorship.

What changes have been wrought by this substitution of business property for that which was personal? Legally, none of any consequence. Joe has, in general, the same rights of dominion and control over the business assets that he has over his personal assets. Subject to the rights of others and subject to any voluntary restricting agreements that he may make, his legal property rights are still entire. Changes have taken place with respect to his property, but they are economic and financial in nature rather than legal. On the economic front, there has been recorded a new business unit: a sole proprietorship possessing valuable place utility because of its accessibility and convenience to the residents of Main Street. On the financial front, Joe has received, or shortly will receive, a credit rating as a proprietor. He has opened up a set of business books, and at the end of the year will be required to complete a special schedule in his income tax forms exhibiting the income, expenses, and net profits of his business enterprise.

In spite of these economic and financial changes however, the establishment of the sole proprietorship business has wrought no new pattern of property rights, as would have been the case had a partnership or a corporation been formed. The assets of the business remain Joe's personal assets in the legal sense, and they will, in the event of his death and in the absence of a special statute or of special will provisions specifically dealing with them, be distinguishable only by description from those other items in his estate.

What liabilities are connected with a sole proprietorship?

Before the establishment of JOE DOE PHARMACY, Joe had from time to time entered into various obligations for himself and his family. A small outstanding account at his family's favorite department store is not unusual, his last car was purchased on the installment plan, and only a few months ago he signed a new lease on his residence. For all these obligations Joe always knew, of course, that he was fully liable.

But what about his liability for the new obligations he is now assuming as proprietor of the drugstore? He is as completely liable under his store lease as he has been, and is, under his house lease. If he buys a delivery truck on the installment plan, he will be as personally liable for any unpaid balance as was the case when he bought his family automobile. In short, there is no legal distinction between his so-called personal liabilities and the liabilities that he creates as a proprietor. In each case he is fully liable and his liability is unlimited and unshared.

Nor would any distinction be made between his business and his personal liabilities in the event of Joe's death – as contrasted with the case were he a partner in a partnership or a stockholder in a corporation. Subject to the prior payment of such items as funeral and administration expenses, subject to the statutory order in which personal and real property and property generally and specifically bequeathed is applicable to the payment of debts, and subject to any outstanding mortgages and pledges, all of his property not expressly exempt by special statute would ultimately be liable for the payment of all his debts. Proprietorship debts would have no preferential right to be paid out of his proprietorship property, nor would personal debts have any priority of payment out of his other property. Naturally, a proprietor may make special provisions in his will with reference to his business or personal obligations, but in the absence of any such special will provisions, his debts would not be separated into the categories of business and personal in his estate; they would be treated indiscriminately.

What are the advantages of a proprietorship as a mode of conducting business?

The advantages of the individual proprietorship as a method of carrying on a business stem largely from its simplicity, the outstanding characteristic of this form of business enterprise. An undertaking owned and operated by one man who hires all his other help may be established without any formal organizational procedures. No special legal requirements must be met, unless the venture is to be conducted under an assumed name or unless the business is to be of a type requiring a state or local license as a prerequisite to its operation. The former is readily complied with and the latter is a requirement unrelated to the form of business organization.

Once established, the pattern of operation of the individual proprietorship is flexible. The single owner – the boss – has the distinct advantage of being able to make decisions regarding its conduct as the exigencies of the business may demand, unhampered by a board of directors or any other impediment to swift and decisive action. Thus, new opportunities may be quickly grasped, new fields of business entered, or old ones abandoned with a freedom of choice and celerity of execution granted only to the sole proprietor.

Owning all of the business, the sole proprietor is entitled to all the profits of his enterprise. This is in direct contrast with the situation in a partnership or in a corporation. In a partnership, each partner receives his agreed share of the earnings of the firm. In a corporation, the profits are corporation profits, and ultimately go to the individual stockholders in proportion to their dividend-paying stock. Thus, except where a corporation is entirely owned by one person – a status in many respects more analogous to a proprietorship than to the ordinary corporation, in spite of the corporate legal structure – other forms of business organization call for the sharing of profits between at least two individuals; often, among several. In the case of the sole proprietor, the profits are his alone.

What are the disadvantages inherent in a sole proprietorship?

Simplicity of structure not only accounts for the advantages of the sole proprietorship as a mode of conducting business, but conversely is the source of its chief disadvantages Foremost among these disadvantages is the complete liability of the proprietor for all the obligations of the enterprise. The sole proprietor alone shoulders the obligations that he can so freely create. His liability is complete and unshared.

This complete liability is accompanied by the full responsibility which the individual proprietor must assume at all times for the conduct of the business. Being the sole boss, he is in a position to call the shots, but by the same token he cannot avoid bearing the burden of all weighty decisions. True, he can delegate many minor responsibilities to his employees (and if he is a capable executive he will do so whenever possible), but the yoke must be borne ultimately by the proprietor himself. Unlike a partner, there is no one on his own plane of responsibility with whom to share the mental load. Unlike the corporate executive, there are no fellow officers or directors with whom he can divide the responsibility for the management of the enterprise.

A third disadvantage of the proprietorship is that whereas the owner is entitled to all the profits, he must also bear all the losses. There are few businesses that can show net profits year in and year out, and when a poor year does come, the sole proprietor must stand the loss alone.

Another disadvantage of sole proprietorships generally is the limited capital funds usually available to them. Ordinarily, such an enterprise must be conducted with the money which the owner can personally put into it, supplemented only by the money he can borrow and the credit he can obtain. Consequently, he must usually forego opportunities requiring considerable investments of capital. But many of these same opportunities might be grasped by a partnership, since the resources of all the partners may be made available, or by a corporation in which the funds of numerous individual investors are pooled to form the capital of a single corporate enterprise.

We now take up that disadvantage of the sole proprietorship which is of most concern: the proprietorship ending with the death of the proprietor. This follows from the circumstances that such a business has no legal entity apart from the owner. Immediately upon his death, the assets and liabilities of the business become assets and liabilities of his estate along with – and in the absence of special statute, special agreement, or special will provisions. not distinguishable from – all of his other assets and liabilities.

Termination of a Sole Proprietorship

What are some of the causes of termination of a sole proprietorship?

Termination of a sole proprietorship may be brought about either by the voluntary act of the proprietor or from causes beyond his control, such as bankruptcy or death.

Voluntary termination. Since he owns and directs the business entirely by himself, the individual proprietor may conclude at any time to cease operations. In such event, he would first fulfill outstanding commitments and then liquidate the assets of the proprietorship in whatever manner he believed was to his best advantage; or he might sell the business as a going concern to a partnership or to a corporation. Again, he might decide to continue the business, but not as a proprietorship. This he could accomplish by taking in a partner or by incorporating the enterprise. Voluntary changes such as these are, of course, a commonplace sight in the daily kaleidoscope of the nation's business.

Death of the proprietor. As previously pointed out, at the death of the proprietor the proprietorship is terminated because it has no legal entity distinct from that of the proprietor as an individual. When a proprietor dies the assets and liabilities constituting the proprietorship immediately become assets and liabilities of his estate along with his so-called personal assets and liabilities.

But his death generates a problem peculiar to a proprietorship business: until an executor or administrator is appointed by the probate court, the business operations must cease entirely since no one possesses legal authority to act. This sudden and immediate interruption of business continuity will persist until a personal representative qualifies in the probate court.

If the proprietor has left a valid will, his property and obligations will be administered by his executor in accordance with its terms. If there is no will, an administrator will be appointed to wind up his affairs in conformity with the applicable probate and intestate laws. Briefly sketched – and consequently oversimplified – the administration of this estate in either event will require his personal representative (executor or administrator, as the case may be) to take possession and inventory all of the deceased proprietor's property, conserve it, convert it into cash (excepting real property, property specifically bequeathed by will, and items agreed to be accepted by the heirs in kind, unless these items are required for the payment of debts or preferred legacies), pay the expenses of administration and the obligations of the deceased, and distribute the remainder to those properly entitled to it.

The procedures as to the proprietorship assets and liabilities are particularly rigid and costly, but departure from them may be made under certain exceptional circumstances. Some such circumstances are the existence of special will provisions relating to the business, the existence of special statutes authorizing a limited continuation of the business beyond the owner's death, or the existence of some form of special business continuation agreement. Here we are concerned with the situation which prevails in the absence of any such special alleviating or remedial circumstances, on the death of a proprietor and its effect in requiring prompt termination and liquidation of the proprietorship business.

What are the economic effects of terminating a proprietorship business?

The deleterious economic effects of terminating the proprietorship business on the death of the proprietor are five-fold. The first relates to the general economy and the others relate to the economic status of those immediately concerned.

Effect on the general economy. The sustenance of our economic life consists of the innumerable commercial transactions occurring continually within the nation. The blood corpuscles that carry this nourishment into every community are its business units – its proprietorships, partnerships, and corporations. When one of these units goes out of existence and its business is terminated, whether it be a large, nationally known corporation or a small, local proprietorship, the economic might of the country is to that extent weakened.

Careers of employees interrupted. Most proprietorships have in their employ one or more employees whose livelihoods and those of their dependents are derived from the business. Termination of the enterprise, of course, destroys these jobs, usually with financial loss to the employee and to the community. To the newer and younger employees, the setback will be temporary, but to those old in years and service, the loss often will be permanent.

Stoppage of income to the family from the business. During the lifetime of the proprietor, his income consists of the profits made from the business transactions of his proprietorship. He and his family live on this income. But on his death, these transactions cease abruptly, except for the completion of any contractual obligations which may have to be carried out by his executor or administrator. With their generating source rendered impotent, profits are no longer made and the flow of sustaining funds to the family is arrested. This loss of income can be substantial.

Possible delay in administration of the estate. Among the duties of the executor or administrator is the carrying through to completion of the unfinished contractual obligations of the deceased proprietor, excepting, however, those contracts that were to have been performed only by him personally. Little imagination is required to visualize many instances where, upon the death of a proprietor, delay in the settlement of his estate will be caused by the necessary performance of obligations that the proprietor has entered into and that have outlived him. Such delays invariably result in increased administration costs, and create vexations, if not hardships, for the heirs.

Shrinkage of assets upon liquidation. It is the duty of the administrator to convert the assets of the estate into money within a reasonable time after his appointment. In the event the deceased proprietor leaves a will, it is the duty of his executor to convert all personal property into cash, except that specifically bequeathed or that permitted by the will or consented to among the heirs to be distributed in kind. Delivery of specific items of property, however, even though directed or permitted, can be accomplished only to a limited degree in many cases, because a substantial amount of cash may be required to pay the costs of last illness and funeral, taxes, executor's fees, legal fees, probate charges, and all outstanding personal and business debts. Normally, delivery in kind of the assets of a proprietorship is utterly impracticable, not only because of the need for cash to pay the above items, but also because the unsuitable nature of such assets makes them unacceptable to the heirs as bequests in kind. Therefore, in the absence of specially designed plans for the disposal of a proprietorship business, it will be incumbent upon the personal representative, whether executor or administrator, to liquidate the assets of the business for cash.

It is common knowledge that the liquidation of the assets of an enterprise usually results in severe losses. Accounts receivable will be impossible to collect in full. The forced sale of inventories must often be made at reduced prices, and equipment