Category: Life Insurance Blog
Business Continuation using the Buy-Sell Agreement
July 29, 2017 Richard Reich
Any closely held small business, like a real estate brokerage, small law firm, or other small service business, whether recently created or well established, should have a specified business continuation strategy to financially accommodate the chance of a proprietor or partner dying, entering retirement, or becoming disabled. The Buy-Sell Agreement will expressly determine how the small business will carry on after a specified event like the death of the proprietor or partner.
Most small businesses have a number of owners or partners who keep control of the ownership shares in the company. If an owner or partner dies without warning, the chances are his or her shares in the business will pass on to a spouse or other family member. Since the surviving loved ones are likely to have very little or no desire in becoming a member of the organization, the surviving owners or partners will need to acquire the shares of the business that was transferred to the surviving family member. This is where a Buy-Sell Agreement will specify the steps that need to be taken so that the company can move forward.
The Buy-Sell Agreement
A buy-sell agreement, also typically referred to as a buyout arrangement, is a legal agreement between co-owners of a small business that governs the circumstances when a co-owner dies, turns out to be disabled, retires, or is required to leave the company.
With a Buy-Sell agreement in place, the remaining business owner(s) will have precise instructions needed to manage certain expected duties such as:
Buy back the shares of the business from the heirs or estate of a principal
Determining a precise value for the company for estate and tax reasons
Limit transferability during life and at death, of ownership control and interest
Affirm and determine which events can activate the right or responsibility to buy or sell
Make it feasible for employees to buy the company from the estate or family members of a principal
The most economical way to supply funds for the financial transactions that will take place immediately after the death of a principal is to utilize Life Insurance as the funding strategy. In most cases, term insurance is the most economical and appropriate product to utilize. There are two common techniques when using life insurance as the financing vehicle:
Entity Purchase Arrangement
This is a succession strategy designed for businesses with more than one owner. The plan is developed by having the business acquire an insurance policy on the lives of every owner in the amount comparable to each owner’s interest in the organization. The company owns and pays the premium for the insurance policies and is the named beneficiary of each insurance policy. Should an owner die, the benefit received by the organization from the insurance policy is utilized to buy-out the departed owner’s portion of the business from the named insured’s estate.
Business owners usually risk a considerable amount of finances and invest a substantial amount of time to get their business up and operating, but some fail to undertake a strategy for continuation when the worse situation happens unexpectedly. Guaranteeing the continuity of your company is as crucial to employees as it is for family members. Simply take the time to understand Buy-Sell Agreements and how they can simply be funded using inexpensive term life insurance.
When utilizing a cross-purchase type of arrangement, each partner or principal is expected to purchase and own life insurance on the other partners or principals. The partner or principal would then pay the policy premium and become the beneficiary on each policy purchased on the others partners or principals.
The death benefit on the insurance policies would match the interest each partner or principal has in the business. When a partner or principal dies, the surviving principals will utilize the death benefit to acquire the shares of the deceased partner or principal from his or her remaining family members or the estate.
The Cross-Purchase strategy will likely prove to be very cumbersome if there are more than a few partners or principals, therefore the company ownership could choose to utilize a “trusteed” cross-purchase agreement.
Using a “trusteed” cross-purchase strategy enables the company principals to employ a third-party organization or person to act as trustee or escrow agent to satisfy the mutual responsibilities to each other that are developed in the cross-purchase agreement.
Which Form of Life Insurance Should Be Utilized?
In circumstances where the principals are only worried about the funding of the arrangement, it makes economic sense to utilize Term Life Insurance as the funding method. Term life insurance, which can be bought with a 30-year term, is the most economical life insurance product mainly because the mortality rate for this product is a great deal lower than permanent life insurance, especially in situations where the principals to be covered are young and healthy.
Since there are numerous highly rated life insurers competing for sales, a 35-year-old male or female can buy Term Life insurance for less than $15 per month per $100,000 of death benefit. Term insurance is a very inexpensive solution to finance a Buy-Sell agreement which is the primary part of any business continuation plan.
How Much Insurance Should Be Purchased?
Since ownership shares in many organizations are split using percentages instead of dollar amounts, the principals need to consider the value of their particular shares over a period of time. It is always more effective to acquire more life insurance if you are unclear what the valuation of the business will be over time. A qualified and reputable independent insurance broker will most likely be able to assist you in determining an appropriate death benefit for each insurance policy, but in any case, you can essentially pocket any funds that are not needed to complete the transaction
What Are The Tax Considerations?
While tax concerns should be addressed by your CPA, there are some basic considerations that can be addressed here:
- All insurance premiums used to finance a buy-sell agreement are not tax deductible.
- The death benefit is delivered tax-free irrespective of who acquired and owns the insurance policy unless the death benefit is payable to certain corporations. The death benefit that is received by the C corp may result in an alternative minimum tax for the corporation. For the death benefit to be received tax-free, there can be no exchange for valuable consideration.
- Insurance premiums paid by a company in which the shareowner is the named insured are not regarded as taxable income to the insured person.
- There is no gift tax responsibility upon the execution of a buy-sell agreement.
- When implementing a cross-purchase agreement, one should be cautious of the transfer for value rule.
Where To Purchase Term Insurance For A Buy-Sell Agreement
Most experienced life insurance brokers who sell term insurance will represent the top ten term insurers. Contact the insurance professionals at Instant Quote Life Insurance at (866) 691-0100 during normal business hours, or you can contact us and get an insurance quote through our website at your convenience.