If you’re a business owner, you’ve spent countless hours growing and developing your company. Part of good business planning is preparing for all eventualities, including the unexpected death or departure of you or one of your business partners. That’s where a buy-sell agreement comes into play.
What a Buy-Sell Agreement Entails
Buy-sell agreements go by many names. You might see them referred to as buyout agreements, business prenups, buy and sell agreements, or business wills. Whatever you call them, the basic principle is the same.
A buy-sell agreement is a contract that details what will happen to someone’s share in a business should they die or otherwise leave the company. We’re going to focus on situations where a business partner has passed away because we’re talking about funding a buy-sell agreement using a life insurance policy.
When someone dies, their family or estate will likely inherit any shares they possess in a business they co-own. Their family might not be interested, qualified, or able to take over the deceased’s business interests. When that’s the case, a buy-sell agreement allows the remaining business partners to purchase the shares from the family.
Different Types of Buy-Sell Agreements
There are two main types of buy-sell agreements: cross-purchase plans and entity purchase plans. Arguably, there’s a third type called a trusteed cross-purchase plan, but is a subset of regular cross-purchase plans, and that’s how we’ll treat it. All are considered business succession plans.
The right buy-sell agreement for your purposes will depend on a variety of factors. Who’s buying the share in the business, who’s selling it, how flexible the plan is, different state laws, taxes or lack thereof, and how many policies needed influences which agreement happens.
A cross-purchase plan refers to a buy-sell agreement in which the partial owner of a business takes out a life insurance policy on the other partial owner(s) of the company and vice versa. Suppose something unexpected happens, and one of the business owners passes away. In that case, the remaining owners can use the life insurance policy’s payout to purchase the shares that used to belong to the deceased from their estate.
Every buy-sell agreement has its own merits, and cross-purchase plans are no exception. Perhaps most significantly, shares transfer under a cross-purchase plan without the possibility of income tax.
An additional benefit is that creditors generally won’t be able to access the payout from the life insurance policy. However, this may vary depending on which state you’re located in.
Despite the associated advantages, cross-purchase plans are by no means flawless. There are two main drawbacks: cost and complexity. The two issues are related.
When a business ownership is by two or three people, a cross-purchase plan might make sense. Any more than that, and suddenly each co-owner is attempting to keep track of and pay for too many life insurance policies to make the plan worthwhile.
Trusteed Cross-Purchase Plans
A trusteed cross-purchase plan can be helpful when there are many different business owners. Instead of every individual co-owner attempting to keep track of different life insurance policies, one trustee is responsible for the buy-sell agreement. The trustee should be a third party.
Everyone’s shares in the business remain in a trust, and the trustee takes out a life insurance policy on each of the owners. Should one of them pass away, their death benefit goes to the trustee. The trustee pays the deceased’s estate for the shares, and the shares split up between the remaining owners.
Entity Purchase Plans
In an entity purchase plan, the company itself takes out life insurance policies on the business owners. If one of the owners passes away, the company receives the death benefit, which it uses to pay the deceased owner’s estate for their stake in the business. Entity purchase plans are popular because it’s the company, not the individual owners, who pay for the life insurance premiums.
Another benefit of entity purchase plans is that the deceased’s estate is likely to see payment quickly, which can help support their family. In most cases, the death benefit has no taxes when the company receives it, although an alternative minimum tax applies. When deciding whether an entity purchase plan is right for you, you should also consider that corporate creditors may be able to access the death benefit.
The possible tax implications of using life insurance to fund a buy-sell agreement are likely at the forefront of your mind. We mentioned them briefly when comparing cross-purchase plans to entity purchase plans, but they’re too important not to go into further detail about. Fortunately, using life insurance for funding a buy-sell agreement is one of the safest and most convenient ways to do so, in part because of the tax advantages it offers.
No matter what type of buy-sell agreement you have in place, the death benefit probably won’t be subject to income tax. A notable exception can occur when an entity purchase plan is in place if the company hasn’t followed the notice and consent requirements detailed in Section 101(j) of the Internal Revenue Service Code.
Estate taxes are generally only applicable to death benefits if the estate itself named the beneficiary or when the person who has passed away owns and is insured by the policy when they die. Because a company, trustee, or individual shareholders are the owners and beneficiaries of the policy, this is rarely an issue.
The most common tax you’re likely to encounter when funding a buy-sell agreement is the alternative minimum tax, and that’s only in some instances when a C corporation is involved. A C corporation is any corporation with taxes separately from its owners. If these circumstances apply to you, you’ll know.
Reasons To Fund a Buy-Sell Agreement With Life Insurance
If you’re thinking buy-sell agreements, particularly those funded with life insurance, sound confusing, you’d be right. However, don’t discount them. The alternatives are likely to cause far more problems.
If you don’t fund a buy-sell agreement with life insurance, you may find yourself paying for the shares out of pocket. Or even with a loan. In cases where a buy-sell agreement hasn’t been set up at all, someone uninterested, uninformed, or who doesn’t mesh with company culture may inherit the shares. That can leave the company’s future uncertain.
Even if every co-owner of the business is young, healthy, and feeling invincible, setting up a buy-sell agreement and ensuring that it’s fully funded with life insurance is good business planning. You may not use it for years. Or at all depending on your circumstances, but having a plan in place for all eventualities helps secure your company’s future.
Business continuity planning is essential for your company’s continued success. Investors, owners, employees, and customers alike will be able to trust in the company’s future stability. This is if there’s a buy-sell agreement in place. The most significant benefit that a buy-sell agreement funded with life insurance offers is protection.
While that’s true no matter what type of business, it’s particularly essential in the case of a sole proprietorship. There are no partners in a sole proprietorship. So an employee is generally the one who takes out a policy in the event of the owner’s death. Without a buy-sell agreement in place, a sole proprietorship may dissolve upon the owner’s death.
Family and Estate Benefits
With a buy-sell agreement in place funded with life insurance benefits the deceased’s family and estate too. This is one of the reasons it’s so popular. The family doesn’t have to worry about managing part of a business. This while also grieving and planning a funeral, which is often a relief.
Additionally, since life insurance pays out in a lump sum, the money is available after the transfer. The family’s financial future is secure.
Reasons Not To Fund a Buy-Sell Agreement With Life Insurance
As convenient as it might sound to fund a buy-sell agreement with life insurance, there are reasons to avoid doing so. The first is the cost.
Even with an entity purchase plan, someone or something has to pay the premium. Unfortunately, life insurance premiums usually aren’t tax-deductible, which can further complicate matters.
Suppose the co-owners of a company differ widely in age and general health. In that case, the younger, healthier co-owners might end up paying disproportionately more than their older or less healthy peers.
In some cases, due to health, age, or lifestyle choices, one or more business partners might be deemed uninsurable. If that happens, you might feel as if you’ve hit a dead end. There are still options, so don’t be discouraged.
Life insurance is complex to begin with. Deciding if and how to fund a buy-sell agreement with life insurance is even more complicated. NextGen Life Insurance offers expert advice to ensure you’re making the right decision for both your company and your family. Get your free quote today, or call us at 646-216-4199 to get started.