How to Fund a Buy-Sell Agreement with Life Insurance and Transition Your Business

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, these agreements play an even more critical role in the successful transition of the business from one generation to the next.

What Is a Buy-Sell Agreement?

Buy-sell agreements control the ownership of a business when a triggering event occurs. The event could be an owner’s death, retirement, or departure from the company; death is the most common, particularly for family businesses, whose owners are unlikely to leave otherwise. As a result, buy-sell agreements also 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. Giving careful attention to your buy-sell agreement and related documents is an important tool for following through on business and personal wishes.

What Does It Cost to Draft a Buy-Sell Agreement?

The initial legal fees of a buy-sell agreement could run anywhere from $1,000 to $5,000. However, the full cost of funding varies dramatically from organization to organization based on the value of the business. 

How Do You Fund a 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. An organization may have a buy-sell agreement stating if one owner dies, ownership goes to the other, but how does the surviving owner buy out the deceased’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, some options are listed below.

Create a Sinking Fund

A business diverts a portion of its revenue into a savings account so liquid assets are available to buy shares of an owner who leaves or passes away. This provides liquidity when it’s needed, but could divert a substantial amount of revenue away from the business’s operations, potentially hampering growth.

Draft a Promissory Note

With a 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. The payments should include interest.

This solution could be easier to manage financially, but the business must record a liability on its books, and the estate could 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 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 their business.

How Do You Fund a Buy-Sell with Life Insurance?

Different Types of Life Insurance

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

Term Insurance for Owner Departure

Will the owners retire, or will the business be sold to a third party in the future? If either situation is a possibility, then term insurance may be best option. There’s a specified period during which the need for insurance to fund a buyout exists.

Permanent Policy for Continued Participation

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.

Common Life Insurance Arrangements

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.

Cross-Purchase Arrangements

In cross-purchase arrangements, every owner personally owns a life insurance policy on one another and is the beneficiary of that policy.

If an organization has two owners, 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.

Entity-Owned Arrangements

The alternative is to have the business itself be 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, 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.

What Are the Tax Implications of Life Insurance Policies?

How you choose to structure your life insurance policies carries tax implications.

In a cross-purchase arrangement, the business generally distributes money to owners to cover premiums. Usually, owners recognize these distributions as additional income. In other words, it’s more money that can be taxed—which could be undesirable if premiums vary substantially between owners.

If, in the example above, owner B is an advanced age 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 borne equally by the owners.

How Does Succession and Estate Planning Factor into a Buy-Sell?

How you structure your buy-sell agreement and insurance policies should depend on your own long-term goals for the 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.

To use our original example, owners A and B own an organization valued at $10 million. Both have children who are involved in the business, and own small minority interests, but neither of their spouses are part of the business. Unless they’ve planned otherwise, upon either’s death, their share of the business will fall to their respective spouses.

Now assume A passes. Their spouse becomes an equal owner of the organization with B. Unless B created some kind of funding mechanism to buy out A’s spouse, B must now continue to operate the business with someone who may have no prior knowledge of the organization.

Instead, let’s say that owners A and B set up a buy-sell agreement where the organization owns insurance on all owners. At A’s death, the organization receives the death benefit proceeds—generally free from income tax. The organization uses those proceeds to purchase A’s interests from A’s spouse.

Consequently, A’s shares are now proportionally distributed among the remaining owners. A’s spouse now has liquid assets, and B is no longer equal partners with A’s spouse.

To learn more about factoring business interests into your estate planning, see our article. If you’re interested in learning how COVID-19 could increase gifting percentages and help you protect your assets during a time of disruption, read more here.

How Often Should You Review Your Plan?

Even the best-laid succession plans, buy-sell arrangements, and insurance policies can fail if they’re not revisited on a regular basis. As a best practice, always review your buy-sell agreement, life insurance, and estate plan in tandem at least every five years. Life insurance should be reviewed on an annual basis. You should also consider a review after a relevant regulatory change or a life-changing event like a marriage, birth of a child, divorce, or change of ownership.

As your business grows, ownership interests evolve, your 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.

It’s important to annually review your insurance. Life insurance should be handled like any other investment; the timing of premium payments, term periods, policy performance can all have an effect on the success of your strategy.

Know the Value of Your Organization

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. Have a clear, definitive, and independent valuation method appropriate to your business to help reduce conflicts and keep the buyout process moving forward.

Work with all of your advisors—together—to create and review your buy-sell agreement, estate plan, and other related documents.

We're Here to Help

If you’re curious to explore other strategies related to transition planning, explore our checklist to learn where you’re able to evolve and include flexibility in your plan.

To learn more about business transition planning, buy-sell arrangements, life insurance, and how they can work in your estate and succession plan, contact your Moss Adams professional.

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