Businesses often need to find different ways to protect themselves, and sometimes, that something that can help is life insurance. Let’s dive into what a buy-sell agreement is and how to get one.
What is a buy-sell agreement life insurance?
A buy-sell agreement life insurance is a legally binding agreement between business owners which requires each one of them to buy out life insurance policies on each other. It puts in place an exit strategy in case a business owner dies. If a co-owner dies, the surviving owners simply buy the decedent’s owner’s shares using the benefit proceeds from the policy.
How it Works
Instead of taking out life insurance on their own, business partners take out policies on each other. This allows surviving partners to be able to buy shares of a deceased co-owner. While the death benefit amount goes to the beneficiaries, part of that amount is used for the business to buy out shares of the company left without an owner.
When a business co-owner dies, a good buy-sell agreement will help to convert the business interest into cash. This cash will be used as a backup for the deceased partner’s loved ones financially. Also, the agreement can be used to ensure smooth succession of the business, or its disposition in case the remaining partners are not willing to remain in the business.
To reassure creditors to the business you will also need the agreements. While it helps set up a succession plan, your creditors will be assured that their loans will be paid back even in your absence. For business owners who don’t want the business dissolved after their death a buy-sell agreement assures them that the business will get a new owner after they pass away.
After establishing why you will need the agreement, you will need to make a choice from two of the options available.
Types of Buy-sell Agreements
There are two major types of buy-sell agreements, the cross-purchase agreement, and stock redemption. Each of them applies differently as explained below.
Terms of the cross-purchase agreement allow business partners to purchase the interests of the other co-owners. In most cases, this kind of agreement works best for small businesses with up to four owners. If the number exceeds four, then the agreement will become costly and difficult to implement, especially when the individuals involved have varying ages, health conditions and other factors used to qualify for life insurance policies.
It will also be difficult to establish the amount of stock that an individual can buy in case of the death of one of the partners. The business may incur high funding costs, considering that each of the current co-owners will be covered by multiple policies.
When the business partner exceeds four, alternative approaches of the cross-purchase agreement are used. A revocable or irrevocable trust can be created through a Trusteed Cross-Purchase Agreement. Here, a trustee, who is a third party, deals with the paperwork involved while making sure that all the terms of the buy-sell agreement are fulfilled by the participating parties.
A Cross-purchase agreement comes with different advantages which include the following;
- Since the business partners take out policies on each other’s lives, they have access to the cash values of the policy.
- With a cross-purchase agreement, there is no risk of losing control, especially after redemption.
- When a partner dies, the remaining co-owners are awarded an equivalent of their contribution to a deceased owner’s shares.
- Funding for the agreement can be done via alternative methods, and not necessarily through a life insurance policy. As such, the incorporated business does not incur tax on death proceeds.
Stock-redemption is applicable to either corporations or businesses which are responsible for the redemption of an interest holder’s shares once they die, retire or get incapacitated. It is less complex when compared to cross-purchase and hence works best where there are multiple owners. The redemption is often funded through a shareholder’s life insurance policy where the corporation is the beneficiary and owner.
Advantages of stock redemption include;
- The corporation has access to the cash value component of the policy.
- The individual owners do not incur direct taxation.
- Shareholders don’t have to take out life insurance policies on each other hence only one insurance policy is in force with each of the stakeholders.
- Individual shareholders do not incur cost differentials as a result of premium spreads caused by ratings, face amounts and age.
- Surviving stakeholders don’t have to go through challenges brought by transfer-for-value.
This is one of the most vital factors of the buy-sell agreement. This is because without the right funding, the agreement will be useless, so, it has to be made before it is established. There are different ways in which a buy-sell agreement can be funded, as shown below.
This is one of the most common ways of funding a buy-sell agreement. Cashflows generated from the business can be used to fund the agreement.
A company can stash away money so as to pay off debts in the future. This is known as a sinking fund. It helps a business to avoid financial blows in the future, especially involving lump-sum repayment. This sinking fund can be used to fund a buy-sell agreement.
Another common method of buy-sell funding is through loans. If the business is not generating enough cash flows, it can borrow money purposely to make the funding.
Also, businesses can purchase capital through life insurance policies to fund a buy-sell agreement.
Decedents Owner’s Shares
The business can also choose to withdraw or purchase a decedent’s owner’s share to fund the agreement. Oftentimes, this is usually done through installment sales.
While all the above funding methods are great, life insurance is the most common and the best way to fund a buy-sell agreement. It has several advantages over the rest of the methods in terms of costs, timing, and the effect on the company. The following are some of the advantages of funding through life insurance.
- The business can easily access the cash value component.
- The funds can be easily accessed regardless of when a redemption or purchase is needed. This is because the benefits are paid faster to the beneficiaries of the policy.
- The cost of a life insurance policy is affordable, and annual premiums can range between 1 to 4 percent of the benefit proceeds.
- Cash values accumulate on a tax-deferred basis.
- Death proceeds of the policy are usually income tax-free.
While there are different options of funding the agreement, it is highly recommended to first consult with an expert for the best advice with regard to your situation.
When funding a buy-sell agreement, there are a few tax considerations you cannot afford to ignore. Income tax is not imposed on the death proceeds, but alternative minimum tax may be imposed on death benefit proceeds from a C corporation.
A business will also incur taxes on any premiums used to fund the agreement. If a business owner is a policyholder, premiums that the business makes will not be classified as taxable income.
Buy-sell agreements also have ownership structures. This happens when the agreement is funded through a life insurance policy. There are different ownership structures involved in buy-sell life insurance agreements.
In a sole proprietorship, a key employee is supposed to purchase a life insurance policy on the life of the owner of the business. As such, using the death benefits of the proceeds they will be able to buy the shares of the owner after they pass away.
Such an arrangement makes it easy to transfer ownership without affecting the liquidity needs of the business. In a cross-ownership, stakeholders are supposed to take out life insurance policies on the life of the business owner. This way, they will be able to buy the shares using the death benefit proceeds once the owner dies or gets incapacitated.
Unlike in a typical buy-sell agreement where business stakeholders take out life insurance policies on each other, corporate ownerships works the other way round. Here, the corporate entity buys life insurance policies on the owners, and it remains both the owner and beneficiary of the policy. So, when an owner dies or gets incapacitated, the corporate can use the death benefit proceeds to buy the shareholder’s owner’s shares.
The shares of the remaining business owners do not increase when the decedent’s shares are bought by the company. Their ownership will increase by a certain percentage but since the shares are not purchased in their names, they remain the same.
With a buy-sell agreement, just like any other agreement, anything can happen. The business can be negatively affected if a key shareholder dies. And the surviving partners, in this case, would suffer a major financial loss and even risk losing the business. But a buy-sell agreement helps avoid such challenges and keeps the business intact during a transition period.
How to Get It
To get your buy-sell agreement you will need to set up a meeting with your accountant and business partners. In a few cases, only when necessary, you will need to meet a valuation expert. Generally, for any buy-sell agreement to be effective it should follow specific ground rules. A proper buy-sell agreement should contain provisions for the successor(s) of the business hedge against the tax burden they may face after inheriting part of the business. Also, a good buy-sell agreement should have a valuation clause, and below are ways on how to go about it.
The first thing you need to do is to establish the buy-sell agreement as soon as possible. The earlier you get it done, the better, even though you can always set it up on a later date. If you start late, especially after the substantive business has already occurred, the process will be daunting.
Take out life insurance policies
In most cases, when business partners sign a buy-sell agreement, the next step is to take out life insurance policies against each other. This way, the surviving partners will be able to access money to buy out shares when a partner passes away. Finances may be tight for the remaining partners and the business may find it hard to buy out the shares of the deceased. But taking out life insurance policies against each of the partners is a great way to ensure that the business continues even after a partner dies.
Don’t Forget Ground Rules
Having a buy-sell agreement is not good enough, you need to ensure that the agreement applies to your business. A proper buy-sell agreement consists of information about events that may result in the sale of the company and this may limit control of the lenders in case of the death of a partner. You want to clearly state the heirs of the business to avoid surprises and frustrations in the future.
Taxes are Important
When creating a buy-sell agreement, you cannot afford to ignore taxes. They can take a plunge on the business’s finances if and when you decide to sell it or if a partner tries to purchase another partner’s shares in the future. So, within your agreement make sure to include a valuation formula to avoid taxes incurred in the event of the sale of the business.
Include a valuation clause
Another important part of the buy-sell agreement is the valuation clause which is used to decide how the value of your company shares will be calculated in your absence. You will have two options to choose from, with the first one being letting a valuation expert make the decisions needed to be made and alternatively, creating a methodology of how to go about it. Either way, the valuation clause must clearly indicate the valuation clause with all the nitty gritty.
When to Get It
Different scenarios may call for a buy-sell agreement, and the lack of one may also have different results. For instance, if your business does not have the buy-sell agreement, part of the shares may end up in the bank’s ownership. Also, you may end up with a business partner(s) who has no understanding of your business or anything that goes into its survival but still benefit from it without making as much effort as you.
You need to know when to get a buy-sell agreement for your business, and below are some instances when you may need to establish one.
When You Need an Exit Plan for Business Partners
Most breakups, even outside of business tend to end up badly. With a business, the most difficult part of a breakup would be to get all partners to agree on splitting terms. At this point, everyone has their opinion and want to be heard. The best solution is to have written terms that partners are aware of and agree on even before the split happens. This way, partners will easily exit since they have all agreed to the terms provided by the agreement.
So, a buy-sell agreement is necessary if you want to avoid future financial risks and unnecessary disagreements between partners.
To Determine a Fair Value Price for All the Partners’ Shares
With a buy-sell agreement, it will be easy to establish the fair values of each of the remaining partner’s shares in the business especially if one or more of the partners make an exit. This way, you avoid overpricing shares of the former partner because the fair value of the price was already stated earlier on.
So, future disagreements between the remaining partners on the buyout price will be avoided.
To Develop a Succession
Unless you want your business to end when you pass away, you will need to sign a buy-sell agreement. Through the agreement, you will be able to create a proper succession plan for your business in case you get incapacitated in the future, pass away, or exit the business.
A succession plan reduces chaos and makes the transition process of the business, ie transfer to the new owner easy. This ensures that the business runs as usual during the period between your exit and the entry of the new shareholder.
To Keep the Business Interests With Remaining Partners
As mentioned before, different scenarios are prone to play out if a partner exits and the business has no buy-sell agreement. The last thing you want for your business is for unexpected stakeholders to take roles they shouldn’t after you are gone. This will bring chaos to the business since there is no stipulations dictating the successor of your part of the business.
Without a buy-sell agreement, anybody from the business or even their next of kin can easily take over the shares you leave behind. An agreement is a great way to ensure that your part of the company goes to the rightful heir and that your co-owners are aware of it. Otherwise, you will be risking the dissolution of the company if the remaining partners cannot come into terms and chances are that a lawyer will be the one to make that decision for you.
Other Types of Business Uses for Life Insurance You Should be Aware of
Apart from funding a buy-sell agreement, businesses can also use life insurance in many other ways as shown below.
As a business owner, you may want to leave your legacy to your loved ones. But while some of them are actively involved in the business, some may not. This may bring chaos when it comes to splitting up the business after you are gone, and in the long run may affect the well-being of the business. To avoid such, a life insurance policy can be taken to help in estate equalization. In that, the death benefit proceeds will go to the inactive family members while the active ones remain as owners of the business. The death benefit proceeds here are usually equivalent to the value of the business.
Banks and other lending institutions will require collateral from a business before issuing a loan. A lender wants to make sure that the business will be able to repay back the loan in the future even when the owner dies or if the business fails before the loan is fully paid. As such, businesses purchase life insurance policies as collateral in order to easily acquire loans.
To Pay Estate Taxes
In the event of your death, your loved ones will be left with the financial burden of paying off estate taxes. To avoid transferring this burden to them, you can purchase a life insurance policy that will be used to pay state or federal taxes for your estate.
Most whole life insurance policies usually have a cash value component. This means that part of the premiums you pay are set aside to accumulate the cash value component. This cash value accumulated can be used for future emergencies, and the business will even be allowed to borrow against the cash value.
Death benefit proceeds from the life insurance policy can be used to replace income sources when you pass away. Your beneficiaries can use the proceeds to pay off the business creditors, credit card bills or other personal needs such as education.
Key Person Insurance
With every business, there are key shareholders that play major roles in the business. And the death or exit of such a key person may greatly affect the business’s well-being. Businesses can ensure key persons in the business to avoid financial losses and challenges that may come with the loss of this person. This income can be used to find a temporary individual while sourcing for a replacement, and it is the same income that the business could use to find the replacement.
As a business owner, you may have no immediate family to leave your legacy to. Or you may have multiple businesses and would want to donate to charity through one of the businesses. In such a case, you may list a charity organization or a foundation as your beneficiary.
The uses for life insurance for businesses are many, and any business purchases life insurance for one or multiple of them depending on their needs.
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