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.
Cross-Purchase Plan
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 other 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 owner 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 shareholder 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.A buy-sell agreement is an agreement between the owners of a business that defines the continuation of the business. The agreement states that the interest of anyone who passes away will be purchased by the surviving co-owners (or by the business) at a price that is agreed upon and stipulated in the agreement.
Why Consider a Buy-Sell Agreement?
Private shareholders of businesses often find buy-sell agreements an attractive option because they have a significant financial interest in the company and surviving family members would be able to conduct a fairly stress-free sale of the business should that be a possible action. Family members may also even be able to receive a sum of cash to use to help support them after the owner’s death.
In simple terms, a buy-sell agreement allows surviving owners of a business to purchase the shares from a deceased partner and not have to worry about bringing the heir(s) of a deceased partner into the ownership group.
The buy-sell agreement also provides a buyout strategy if the sole owner of a business wants to leave the business to an employee or group of employees rather than surviving family members. A buy-sell agreement will legally specify what will happen if an owner of a business dies, becomes disabled, or cannot perform his or her responsibilities associated with his or her ownership.
The Elements of a Buy-Sell Agreement
As a defined succession or continuation plan for your business, there can be numerous elements specified to protect the interest of the owners of the business. Although there are many elements to consider, there are some that are considered key elements and should be contained in all buy-sell agreements:
| KEY ELEMENT | PURPOSE |
|---|---|
| Parties to the Agreement | For your buy-sell agreement (contract) to be valid, there must be at least two parties to the contract. Typically the parties to the contract are partners or owners of the business unless the agreement is made between a sole owner and his or her employee(s). The creator of the agreement must also identify whether any legal obstacles or licensing requirements could hinder the transfer of ownership. |
| Qualifying Events | The qualifying events that would trigger a buyout must be specified in the contract. Typical events would be death, disability, divorce, or retirement. It's important, however, to consider unusual events that could affect business such as breach of contract, malfeasance, or loss of reputation. |
| The Valuation Clause | You certainly can't have a buy-sell agreement without defining the value of the business. The value must be accurate and accommodate the business's growth over time. This can be done using an experienced business appraiser that should be knowledgable about your industry and have the ability to formulate an anticipated rate of growth rather than creating a new agreement every time there is a significant increase in the value of the business. |
| Funding the Buy-Sell Agreement | To be certain that each buyer has the financial ability to honor the payment terms in the contract, it makes financial sense to use life insurance as a funding vehicle rather than take the chance that each party to the contract will have the cash on hand to honor his or her share of the agreement. |
| Tax Consideration | Since buying or selling ownership of a business can be a taxable event, it's critical to get the input from a CPA or tax professional to minimize any possible tax liability resulting from the agreement being triggered. |
Funding a Buy-Sell Agreement with Life Insurance
One of the most popular ways of funding a buy-sell agreement is with life insurance in a cross-purchase buy-sell agreement. These agreements state very clearly what would happen in the event that one of the owners dies or becomes disabled. The surviving owners agree to purchase that owner’s interests in the business. For each owner, a life insurance policy is purchased and has a death benefit equal to the current value of each owner’s share of the business. It should be noted that in order to take into account the potential future increase of value, benefits greater than the current business value can be purchased as well.
The Details of the Agreement
Buy-Sell agreements can be funded with either permanent (cash-value) or term life insurance. The difference between the two types of policies is that the cash value of a permanent policy can be used for non-death related buyouts. Both types will pay the death benefit, however.
The beneficiary can use the benefit received to pay the estate of the deceased owner an amount that is equal to the value of his or her business interest. In the event that additional life insurance was purchased as key-person insurance, that money could be used by the business to offset any income loss resulting from the owner’s death.
Advantages of Funding Buy-Sell Agreements with Life Insurance
Life insurance proceeds are normally paid within a very short amount of time after one’s death, so the buy-sell transaction can be quickly settled. Additionally, life insurance proceeds are usually income tax-free, and there are different types of agreements to choose from in addition to the aforementioned cross-purchase agreement. In an entity purchase agreement, the business itself buys separate policies on the lives of each co-owner, pays the premiums, and is the owner and beneficiary. A hybrid policy, often also called a “wait and see” policy, allows features from both the cross-purchase and the entity purchase models.
Tax Considerations with a Buy-Sell Agreement
While tax concerns should be addressed by your CPA, some basic considerations 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. In order 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.
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