Risk is an inherent factor of owning a business; however, that doesn’t mean some risks can’t be mitigated. Business owners should take steps to protect themselves in the event of a partner or shareholder’s death. A common document to protect against this risk is a buy-sell agreement. A buy-sell agreement is a contract between owners of a business, and it sets a pre-determined sales price should certain events occur, such as death or disability.
While a buy-sell agreement is an excellent place to start, the agreement alone is often not sufficient protection for the business and its owners. The next step is to fund the agreement with a pool of money or assets that can be deployed when the agreement is triggered. By funding the buy-sell agreement, the other owners of the company will have the resources available to purchase the deceased partner’s share of the business and ensure the beneficiaries of the deceased will be compensated adequately and fairly. This prevents the surviving family members from being forced into an active business role and protects the other owners from having an unintended partner.
One of the most common ways to fund a buy-sell agreement is through the use of life insurance. There are three common types of buy-sell life insurance agreements: cross-purchase, stock redemption, and a hybrid of the two.
In a cross-purchase agreement, each owner purchases a life insurance policy on the other. In the event of one owner’s death, the surviving owner uses the proceeds from the death benefit to purchase the deceased owner’s share of the business. The advantages of this method are that it is easy to administer and the proceeds are free from income tax. One of the drawbacks is that disproportionate insurance premiums are required when owners are of significantly different ages or have health issues. In addition, if there are more than two owners, each owner needs to own a policy on each of the other owners. The formula for the number of necessary policies is the total number of owners, multiplied by one less than the total number of owners, or n*(n-1). Using this formula, a 3-partner business would need 6 policies.
In a stock redemption buy-sell plan, the company pays for the insurance, making the entity the owner, premium payer, and beneficiary for life insurance on each of the business owners. At the death of one of the owners, the business uses the proceeds to purchase the deceased owner’s interest from his or her estate. The main advantage to this method is that only one policy per owner is needed. The business pays for the premiums, as well, which can eliminate the disparity of premiums between owners.
In a hybrid plan, sometimes referred to as a “wait-and-see” plan, the decision as to who purchases the deceased’s business interest (the business owners or the company) is delayed until the first death. The policies can be owned by the business like the stock redemption plan, or by the individual business owners, like the cross-purchase plan. At the first death, the business can decide to purchase the decedent’s share of the company, or defer that decision to the business owners, which may allow them to make a buy-out decision that is most beneficial in managing their tax impact.
Buy-sell agreements have multiple legal, financial, and tax implications. Make sure to consult with your attorney, tax advisor, and Certified Financial Planner™ professional when making decisions on buy-sell agreements and how to properly fund them.