To Transition Your Business to the Next Generation, Look Closely at Your Buy-Sell and Life Insurance

Buy-sell agreements are one of the most important elements in the planning for any business’s long-term success. But for family-owned businesses—common in agribusiness, food, wine, and forest products—they play an even more critical role in the successful transition of the business from one generation to the next.

Why Create a Buy-Sell Agreement?

Buy-sell agreements control the ownership of a business when a triggering event occurs. This may be an owner’s death, retirement, or departure from the company, but death is the most common, particularly for family businesses, whose owners are unlikely to leave otherwise. This being the case, buy-sell agreements play a critical role in estate and succession planning.

Whoever inherits a business owner’s estate—be it a spouse, heir, or other potential beneficiary—may also inherit the deceased’s ownership interests. For many businesses, that’s not the desired outcome. A survivor who inherits a business may have no desire to be involved; meanwhile, the remaining owners may find themselves with a new and potentially unwanted business partner. This is where giving careful attention to your buy-sell agreement and related documents becomes an important tool for following through on your business and personal wishes.

Funding Your Buy-Sell Agreement

It’s all well and good to create a buy-sell agreement that details how ownership should change upon an owner’s departure or death, but unless that buy-sell agreement is funded, it’s unlikely it’ll be executed successfully. A farming operation owned by two brothers may have a buy-sell agreement stating that if one dies, ownership goes to the other, but how will the surviving brother buy out the deceased brother’s shares? This is a common trouble spot in buy-sell agreements.

There are a number of ways to fund a buy-sell agreement, each with its own pros and cons:

  • Create a sinking fund. A business diverts a portion of its revenue into a savings account so liquid assets are available to buy the shares of an owner who leaves the business or passes away. This provides liquidity when it’s needed, but it diverts a substantial amount of revenue away from the business’s operations, potentially hampering growth.
  • Promissory note. Ownership interests pass into the deceased’s estate, and the business or surviving owner purchases the deceased owner’s share from the estate through installment payments, which should include interest. It’s easier to manage financially, but the business must record a liability on its books, and the estate must wait a long time to be paid in full. Furthermore, there’s no clean break between the business and the deceased’s estate.
  • Use life insurance. If death is the triggering event, life insurance provides the cash to fund a buyout when it’s needed. However, the feasibility of this funding mechanism is dependent on the insurability of the owners. Using life insurance to fund a buy-sell agreement is a simple and elegant solution, but it may not be right for every business or owner.

Each owner should take the time to do a careful analysis to determine the appropriate funding method for his or her business.

Funding a Buy-Sell with Life Insurance

Type

There are different types of life insurance, and one size doesn’t fit all. Owners and businesses must look to their desired goals in determining what type of insurance is most appropriate for them.

Will the owners retire, or will be the business be sold to a third party in the future? If either of these situations is a possibility, then term insurance may be the best option. There’s a specified period during which the need for insurance to fund a buyout exists. However, if the owner plans on participating in the business indefinitely—with no intention of ever retiring—then a permanent policy may be more appropriate. In this scenario, there’s no specific time frame, so the insurance need may continue until death.

Structure

When using life insurance to fund a buy-sell agreement, the two common arrangements are cross-purchase and entity-owned arrangements. Each arrangement defines how the life insurance will be owned and how the buyout will occur.

In cross-purchase arrangements, every owner personally owns a life insurance policy on each other owner and is the beneficiary of that policy. To return to our example, take a farming operation owned by two brothers (A and B). In a cross-purchase arrangement, A purchases a policy on B and B purchases a policy on A. This works well with two owners, but what happens when A brings his daughter, C, into the business? Now we have three owners, and if we continue in the same mode, A must own policies on both B and C, B must own policies on both A and C, and C must own policies on both A and B. That’s a total of six policies. As you can see, the number of policies increases rapidly as more owners are added.

The alternative is to have the business be the owner and beneficiary of life insurance policies on each owner. This reduces the number of policies to three: one each on A, B, and C. When one owner dies, the business receives the death benefit, funding the purchase of the deceased’s shares and distributing the interests across the remaining owners. In addition to reducing the number of policies, this means there’s only one transaction to structure when an owner dies, since remaining owners don’t personally have to buy their portion from the deceased’s estate.

How you choose to structure your life insurance policies carries tax implications as well. In a cross-purchase arrangement, the business generally distributes money to owners to cover premiums. Owners usually recognize these distributions as additional income. In other words, it’s more money that can be taxed—and that may be especially undesirable if premiums vary substantially between owners.

Say owner B is elderly and in poor health. Owners A and C will have to recognize a larger amount of income to cover their policy premiums on B, potentially bumping up their tax rate. On the other hand, if the business owns the life insurance policies, the business pays the premiums directly to the insurance company. There’s no individual liability for the premiums, and the disparity of premium amounts is equally borne by the owners.

Putting It All Together: Succession Planning

Now that you’ve got a handle on how life insurance funds a buy-sell agreement, let’s look at an example of how it can be used to put a succession plan into action.

Using our original example, brothers A and B own a dairy farm valued at $10 million. Both have children who are involved in the business and own small minority interests, but neither of their spouses is part of the business. Unless they’ve planned otherwise, at either’s death, their share of the business will fall to their respective spouses. Now assume that A passes. His wife is now an equal owner of the dairy with B. Unless B created some kind of funding mechanism to buy out A’s wife, he must now continue to operate the business with someone who has no knowledge of farming.

Instead, let’s say that brothers A and B set up a buy-sell agreement so the dairy owns insurance on all owners. At A’s death, the dairy receives the death benefit proceeds (generally free from income tax). The dairy uses those proceeds to purchase A’s interests from A’s wife. Consequently, A’s shares are now proportionally distributed among the remaining owners. A’s wife now has liquid assets to maintain her lifestyle, and B is no longer equal partners with someone who is uninvolved in the dairy business.

Naturally, how you structure your buy-sell agreement and insurance policies should depend on your long-term goals for your business. But with careful planning, an understanding of your options, and a bit of teamwork on behalf of your business and personal advisors, you’ll be able to execute a strategy that aligns with your goals.

Review Your Plan Regularly

Even the best-laid succession plans, buy-sell arrangements, and insurance policies can fail if they’re not revisited regularly.

As your business grows, ownership interests evolve, long-term goals shift, and the value of your business continues to increase. The business value you’ve based your buy-sell funding on can become outdated quickly, and with it, the amount you’ll need to buy out a departing owner. In addition, it’s important to consistently review your insurance. Life insurance should be handled like any other investment: The timing of premium payments, term periods, and policy performance can all have an effect on the success of your strategy.

This brings us to another piece of the puzzle: valuations. Unless you know the value of your business, you can’t know how much it’ll cost to buy out a deceased owner’s share. There are many ways to value a business, so be explicit in your buy-sell agreement. Having a clear, definitive, and independent valuation method that is appropriate to your business will help reduce conflicts and keep the buyout process moving forward.

To keep your business valuation, buy-sell agreement, life insurance policies, and estate planning documents working in harmony, review them:

  • At least every five years, though insurance should be reviewed annually
  • When there’s a relevant regulatory change
  • When there’s a life-changing event, such as a marriage, children, divorce, or change of ownership
  • When there’s a significant change in the value of your business

Most important, work with all of your advisors—together—to create and review your buy-sell agreement, estate plan, and other related documents. Without a view into what each advisor is doing, it’s unlikely they’ll all align toward your ultimate goals. As a best practice, always review your buy-sell agreement, life insurance, and estate plan in tandem.

We're Here to Help

To learn more about buy-sell arrangements, life insurance, and how they can work in your estate and succession plan, contact your Moss Adams insurance specialist or accounting professional. We can help you gain perspective on your long-term goals and align your plans, putting you on track to achieve them smoothly and effectively.