A buy-sell agreement is a contract between closely held businesses owners detailing what they wish to happen to each owner’s share of a business upon a triggering event. Triggering events may include death, disability, retirement/termination, bankruptcy, divorce or disputes.
Events Impacting The Business Partner
Within a closely held business, owners are often concerned about what might occur if something happens to them, or their business partner.
- How will the business continue to operate?
- Who will control the business in the absence of one of the partners?
- Will the family members of the deceased or disabled owners become involved?
- Do I want to deal with the ex-spouse of one of the owners in the case of a divorce?
- How will the remaining owners fund the buyout of the owner who is no longer part of the business?
Given these concerns, business partners are best served by entering into a buy-sell agreement, ideally at the outset of the business venture.
Life insurance as a funding mechanism
A thoughtfully drafted Buy-sell agreement is only part of the equation; selecting a proper funding mechanism which can assure liquidity to fund the agreement if a triggering event occurs without causing financial hardship to the parties involved, is equally as important. The primary funding options typically include utilizing current business cash flow, a “sinking fund”, a loan, or Life Insurance.
Life insurance is often the ideal funding mechanism for multiple reasons:
- Its immediate liquidity can prevent a fire sale.
- Death benefits proceeds are generally income tax free
- Funds are purchased for pennies on the dollar.
- Premiums are typically significantly lower than loan interest.
Typically either a Term Life insurance policy or Permanent cash value policy such as Whole life or Universal life are utilized. Term life insurance is generally less expensive, but has it’s limitation. On the other hand, Permanent cash value life insurance has numerous potential benefits for both business needs and fulfilling the agreement.
For example the cash value in a permanent policy can be used to partially fund the buy-sell agreement for a triggering event other than death, such as Disability. Secondly, The cash value of the policy can be used in the form of a loan, to fund some, or all, of the agreement when needed, as well as for other business funding needs. Also, the policy’s cash value is a liquid asset of the corporation that may help secure advantageous low interest rate loans for company use from a commercial bank.
Depending on the structure of your buy-sell agreement (more on this later), the business may be able to carry the policy cash value on it’s books as a company asset (talk to your accountant). This asset can be accessed in the form of a loan for other business uses.
Lastly, when an owner retires, the ownership of a permanent cash value policy can be transferred to the retiring owner (the insured). The insured can then use the policy and it’s cash value in any manner of their choosing. They can name their own beneficiary for the death benefit and/or use the cash value to supplement their retirement income. There may be income tax consequences to this transfer, so make sure to consult your accountant or tax professional.
Types of Buy/Sell agreements
Without getting too far into the weeds here, Owners usually choose from two basic types of buy-sell agreements, though there are multiple iterations and variations.
A cross-purchase agreement, each owner of the company purchases an insurance policy on the other shareholder. The purchaser is both the owner and beneficiary of the policies. Upon the death of a shareholder, the other shareholder is then able to use the life insurance proceeds to purchase the deceased owner’s shares. This type of arrangement is typically best suited when there are 2 partners/shareholders.
A stock redemption agreement – the corporation owns policies on the lives of the shareholders. When a shareholder dies, the corporation buys the deceased shareholder’s interest in the company using the Life Insurance funds. This type of arrangement is typically best suited when there are 3+ partners/shareholders, as well as if there are significant age and health disparities between the owners. Since the company will be paying the premiums, the cost difference will be shared by the company.
These plans are not set it and forget it, they ought to be reviewed regularly and changes made as necessary. A thoughtfully drafted and adequately funded Buy/Sell agreement can bring owners peace of mind, assure families will be taken care of, and position the company for a successful future.
“We can help design the proper Life Insurance program for your business continuity plan based upon your cash flow, risk tolerance, and funding needs. We work with Business Transaction and Estate Planning attorneys who can properly structure, customize and draft the right agreement specifically for your business and its unique circumstances. Contact us at 248-362-1313 or fill in the form below and we can start the process.
