Buy-Sell Funding with Life Insurance

Business Continuation Planning - Before It's Too Late

Following the death of a business owner, any remaining owner(s) will face major decisions with limited solutions. As a result, their business future may be in jeopardy.

They generally face four alternatives:

1. Accept Heirs into the Business
2. Accept Outsiders into the Business
3. Sell the Business to the Heirs
4. Buy the Business from the Heirs

A properly drafted and funded Buy-Sell Agreement will provide for the sale of the owner's business interest at death, disability or retirement. Additionally, it may:

• Assure the transfer of the business at a price and on terms that are acceptable to all parties. (This means a forced sale or liquidation can be avoided)

• Provide liquidity. A disabled or retired owner can diversify his/her investments and generate income. At death, the buy-sell proceeds can help pay estate taxes and other debts or administration expenses.

• Maintain control of the business for surviving owners. The deceased's heirs will not take control or create conflict with the remaining owners' objectives.

• Help retain key employees. If/when the death, disability, or retirement of an owner occurs, the business will continue. Key employees will remain employed and content.

• Establish value for estate taxes. If the agreement is properly drafted and its provisions are followed by the parties, the IRS may accept the business value for estate tax purposes.

Buy-Sell Agreements
There are two primary forms of buy-sell agreements: 1) the Cross Purchase Plan and 2) the Stock Redemption or Entity Purchase Plan, as shown below. These agreements may address buy-sell options upon an owner's death, disability or retirement. A written agreement is always recommended by legal counsel.

Type 1:

Type 2:

Here's an example of the Cross Purchase Buy-Sell:

• The life insurance policy premiums are not deductible.

• Life insurance policies may be protected from personal creditors.

• If there is a wide disparity in ages, or an owner does not receive a policy at standard rates, the premium differential in the policies may be significant.

• Upon the death of an owner, the surviving owner(s) use the life insurance proceeds to help purchase the deceased's business interest under the terms of the agreement.

• Since each owner must purchase a policy on every other owner, this may be difficult to administer if there are more than two owners.

• Each owner agrees to purchase the interest of a deceased co-owner at an agreed price.

• Each owner applies for, owns, pays premiums and is the beneficiary of a life insurance policy on the other's life.

Here's an example of the Stock Redemption/Entity Purchase Buy-Sell:

• The business agrees to purchase the interest of a deceased owner at an agreed price.

• Business applies for, owns, pays premium and is the beneficiary of a life insurance policy on each owner's life.

• Upon the death of an owner, the business uses the life insurance proceeds to help purchase the deceased owner's business interest under the terms of the agreement.

• Since the business pays the premiums, differences in policy premiums may not be a concern to the owners.

• Only one policy per owner may be required, regardless of the number of owners.

• The policy premiums are not deductible by the business.

Wait and See Buy-Sell Agreement
Funded by Life Insurance at Death

Since it is impossible to know what the future holds, the decision between Cross Purchase or Stock Redemption (Entity) can be difficult. The Wait and See is a hybrid agreement which contains elements from both types of the buy-sell agreement. The final buyer of the business will not be determined until after death occurs.

• The agreement obligates either; a) the business or b) the owners to purchase the decedent's interest at death. The other party then has the first option to purchase this interest.

• The party(s) with the obligation purchases life insurance as a cross purchase (if the owners have the obligation) or stock redemption / entity arrangement (if the business has the obligation).
  
• The party(s) receiving the life insurance proceeds use them to help purchase the business interest for themselves, or can lend to other party(s) to help them finance the purchase.

• No decision needs to be made about the purchaser until a business interest is due to be purchased under the agreement. This provides flexibility for changes in economic times, tax laws, and the owner's circumstances.

Funding a Buy-Sell Agreement

Pay Cash:

• May require large sums of assets that might not be available.
• In some instances, the funds may need to come from personal or business assets.
• Either way, if any assets must be sold, will their fair market rate be readily available?

Borrow the Money:

• The loss of an owner, especially if a key person, may impair the credit rating of the business.
• Both the principal and interest must be repaid and could place a tremendous strain on the budget.

Purchase a Life Insurance Policy:

• Money available from death proceeds is available exactly when required.
• Death proceeds are generally income tax-free.
• May be the most economical.

Funding With Life Insurance
Benefit Summary

For the Deceased Owner's Family:

• Their business interest is sold at a fair price.
• Provides a ready buyer for their business interest.
• Provides cash to replace lost family income.
• Provides cash to pay estate settlement costs.

For the Surviving Business Owner(s):

• Continuity of business operations.
• Provides the means to buy the deceased's business interest with income tax-free death benefit proceeds.
• Removes heirs of the deceased from future involvement.

Life insurance may be the most economical funding method.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.