Buy-Sell Agreements and Life Insurance
Buy-Sell Agreements and Life Insurance
How a Buy-Sell Agreements and Life Insurance works
3 Ways it Could Save Your Business
Buy-Sell agreements and Life Insurance are at the top of the ranks when it comes to frequently used methods of keeping small businesses running. It takes years to build a successful business. Anyone who has done so understands the importance of proper planning.
Buy-Sell Agreements provide survivors a manageable way to regain interest in the company or small business. The death of a small business owner can be devastating. It is one of the leading causes of a business to fail long term.
Planning for death can be a common mistake found with Buy-Sell Agreements and Life Insurance. You also want to make sure you cover your basis on disability and divorce situations. At Good Life Protection, we strive to provide you with information needed to make an informed decision regarding your business. At Good Life Protection we do not structurally set your buy-sell agreement. We do, however, provide the most updated information we can. Also, our team can help you find the best life insurance policies possible to fund your buy-sell agreements.
Life Insurance can be one of the best planning tools for funding a buy-sell agreement.
- How do a Buy-Sell Agreements and Life Insurance work?
- What is the best methods and practices?
- How much will it cost?
These are all common questions we help our clients with daily. We want to take the time to discuss them more in depth, but let’s cover some of the basics first.
What is a Buy-Sell Agreement?
A buy-sell agreement primary purpose is to provide a cash payout to surviving hires for the sale of the decedents business interest. Without this arrangement in place, the business interest presents several problems. I will elaborate on these problems further in this post. A buy-sell agreement basically acts as a legal document protecting all business owners interest in the said business.
A buy-sell agreement is a binding contract. It even states the price at which a previous business owner must sell or take for his or interest in the business. A buy-sell agreement is typically referred to as a buyout. A majority of the time, buy-sell agreements are funded with life insurance.
The primary reason for this is, it is the only way of providing a full proof guarantee in the event of a death to one of the business owners involved. It is typically the easiest method to choose from.
What are the common terms of a Buy-Sell Agreement?
First and most importantly, you are going to have your parties involved. A buy-sell agreement is going to have provisions within, indicating and identifying all parties to the arrangement.
The intent to the party’s wishes is key. What are you wanting to happen? Two things will happen; you want to make sure align based on all parties wishes and goals. The buy-sell agreement should all contain provisions that detail the intent of all parties. This also proves valuable and time-saving for you. Also for everyone else involved if a said dispute arises later.
What happens once the buy-sell agreement is in place is also a huge factor. The roadmap of what needs to happen after the death, divorce, or split interest in a business needs to be completed.
An example of this could look like this
Upon the death of Business Owner X, Business Owner Y and Z will purchases Business Owners X share of the company from Business Owners X estate according to the terms of the agreement.
Actual Business Interest- Detailed and Descriptive
What you think your business is and what the agreement entails could be different things. Your actual buy-sell agreement should always detail and describe the actual business interest subject to the agreement.
Transfer Restrictions During a Lifetime
First, offers and rights of refusals is a typical clause and provision placed within your buy-sell agreement documents. It ensures that the parties involved will not dispose of the business interest to outsiders while the parties are living.
Although we would like to think that all business relationships formed in the creation of a small business, it never hurts to make sure things are documented. Documented with clear intent and direction to ensure the business and your interest are protected and honored.
The parties and or party need to come up with a purchase price for the remaining interest in the business. It should always specify a fixed purchased price. Also, a method for determining how the business interest can be allowed to be purchased and sold.
This is where Life Insurance and Buy-Sell Agreements go hand in hand. How the agreement will be funded is arguably the most important factor to have planned. Life Insurance is the most common method used for buy-sell agreement funding. The documents and agreements need to detail what kind of policies are being used to fund the agreement. The life insurance will provide immediate funds to uphold the buy-sell agreement. Also, it will keep the business moving in the correct direction.
The agreement should describe the specifics of funding and transfer.
- Where will the settlement occur?
- What are parties participation of the transfer agreement?
Termination and Modifications
Things change, there is nothing wrong with that and it is understandable. Keep up with the times and changes. Make sure your agreement always serves its purpose and achieves all the party’s objectives.
Listed above is going to be your general format of how a buy-sell agreement is structured. Which kind of buy-sell agreement should you enter?
3 Kinds of Buy-Sell Agreements
The most important factor to understand is that buy-sell agreements should be tied together with an overall estate planning strategy. Good Life Protection does not offer legal advice or estate planning coordinating. Although, we can be a piece to your puzzle in funding your buy-sell agreements with a tailored life insurance policy to fit your needs.
Buy-Sell Agreement Option 1- Mandatory Buy-Sell Agreements
This is which the company or buyers are required to purchase the descendants’ interest.
The Right of First Refusal
This form of a buy-sell agreement is going to offer his or interest to the company first and give them a right at first refusal. And then finally you have…
Business Interest to heirs
This form of a buy-sell agreement is going to offer the business interest to the descendant’s heirs first.
All these are solid planning tools. They can be used to match your individual goals and descendants needs.
So why enter into a Buy-Sell Agreement?
This list could be much longer, but I wanted to only cover some of the basics.
Business Continuation Agreements
A Business Continuation Agreement is when the primary goal is to continue the business following a death of a primary business employee or owner. The next thing that needs to be considered with buy-sell planning is what kind of business are you?
This can make a very big difference in the planning aspects of your agreement and funding.
It is broken down into three main categories for business types.
A sole proprietorship is a business that has only one individual owner. The most important part of this form of business is that it is not treated as a business entity separate of itself. Nothing legally separates the business owner’s assets from the business assets. If the owner of a sole proprietorships passes away, the entity must end as well. Planning for this will be vital to the business being able to survive and continue.
Usually, a buy-sell agreement for these instances is used to guarantee a definite sale and purchase when the time presents itself. In a nutshell, it binds the descendant’s estate to purchase the business interest after death.
So, would be the purchaser of my Sole Proprietorships?
In many instances, it may be obvious who the purchasing party should be. Often it could be…
- An adult child of the deceased business owner
- A close family member
- Possibly, even a key man in the business who understands how to run and continue the business.
If you do not know off the top of your head who you should be giving these roles or opportunities too, it is often advisable to hire an employee. You should groom them in a manner that would allow them to continue the business at its natural flowing performance.
Life Insurance Funding for Buy-Sell Agreements on Sole Proprietorships
This part of the arrangement is easy. The purchasing party will be obligated to provide sale proceeds to the decedent’s estate. The applicant would be the:
- Owner of the life insurance policy
- Payor of the premiums on the life insurance policy
The insured would be the sole proprietor.
You do need to make sure that the coverage is adequate. It needs to be enough coverage to suffice for all required payments to the estate of the deceased. Reviewing the life insurance coverages for these types of agreements should also be performed periodically. Your business may grow in value over time. Reviewing your coverage needs will ensure you stay up to date to provide for your death.
Typically, when one partner passes away, by law the partnership terminates. This may not be the desired outcome you are looking for. The most common way to avoid this pitfall is to have a plan in place before it happens. Without this plan, you will be forced to liquidate your partner’s interest upon his or her death. The price at which liquidation occurs must be deemed at fair value.
In most circumstances, this is going to prove to be difficult for the surviving party. It would impose a burden very hard for you to climb out of without proper planning. Most often, the payments would have to come from the business income, in return, diminishing the businesses profits and overall chance of survival.
The entire goal you want to aim for is to be able to continue the business with no speed bumps if possible. You want to keep your liquidations payments to an absolute minimum if possible.
A well-crafted buy-sell agreement. The documents should support the real chance of one partner passing away. Each partner would be agreeing to sell his or her estate or interest in the business at first death. This would allow the partner to again, continue the business with minimal interruption.
Inside these agreements, you will want to have it contain mutual binding promises. The proceeds or funding would be used to cut the other parties interest in the business and keep it alive and running.
Within Partnerships, you have three forms of Agreements for the Buy-Sell Agreements-
First, you have the Entity Purchase Agreement
The partnership itself becomes the purchasing party in the agreement. The easiest way to put it is, the entity (partnership) liquidates the interest held by the decedent’s estate. The business makes payments to the estate that liquidates the interest. It gives the surviving parties control of that part of that business.
Then you have number 2- Cross Purchase Buy-Sell Agreement
With this form of a buy-sell agreement, you and your partners would make mutual promises to be a buyer or seller depending on the circumstances. Each of you virtually agrees to purchase a share of any of the deceased partners’ interest. The deceased partners’ interest would be bound to sell its interest in the partnership to the surviving partners.
Several determining factors of which way to go should be considered before deciding which agreement to enter.
- How many partners are involved?
- What will the tax consequences of each agreement be?
- What will the cost basis be for each surviving partner?
Consideration from each partner and a careful financial overview should help provide you with a clear path on which agreement to enter.
How does Life Insurance Play a Role with these Agreements?
Entity Agreement (Liquidation)- Since the entity in this approach is forced to liquidate the interest of the partnership at death, life insurance can be a great tool to fund the arrangement. The partnership would be the:
- Applicant- Individual or Entity applying for the life insurance policy or signing documents
- Owner- Person or Entity holding intangible property rights to the policy- Premium Payor
- Beneficiary– Person scheduled to receive all death benefit or proceeds from the life insurance policy
If the owners of the policy maintain proper coverage amounts on the life insurance policy, it will be the obligations needed without issue. Usually, the deciding factor to picking this approach is the financial status of the parties involved. If the partnership or business can make payments with more ease, they would be the purchaser in this setup. It would relieve the financial burden on the individuals involved in the partnership. Often you will have many people involved in these agreements.
Cross Purchase Agreement
As we discussed before, this form of agreement will provide that surviving partners are obligated to buy a set amount or shares of a deceased partners interest from his or her estate. The best way to fund these agreements is with Life Insurance policies. Each partner would need to buy a life insurance policy on all other partners involved. This means, if you had four partners involved, you would need a grand total of 12 life insurance policies to structure this correctly.
When one partner dies, the surviving partners would be entitled to the policy proceeds that would be transferred over to the deceased partners estate. When you fund with a life insurance policy you would be swapping the proceeds to pay the estate. You would gain control of that partners interest in the partnership.
Closely Held Corporations
A corporation is the first entity we have discussed that can differentiate the entity from the shareholders. It provides that the shareholders and the entity are separate taxpayers. Within corporations, usually, a select few of the employees or shareholders would be deemed as the key men or women. Or be very important to the corporation’s survival after death. Any deaths of these key individuals would place an immediate strain on the corporation. Whether it is in the form of death, retirement, or disability. This may be the most important entity we discuss for buy-sell agreements to be considered.
3 Ways to Structure these Buy-Sell Agreements for Corporations
Stock Redemption and Buy-Sell Agreement
The corporation in this scenario would be if you are the purchaser of the stock at the death of a shareholder (key employee). Each person involved, or shareholders would bind his or her share to his or her estate. The estate would be forced to transfer the stock to the corporation in exchange for the required set purchase price. At this point, the corporation can either retire the shares of stock or hold them as “treasury stock”. The reason behind doing this form is because each shareholders interest in this corporation would climb upon the death of the shareholder or key employee.
Entity Purchase Buy-Sell Agreement
This will look exactly like we discussed before with partnerships. Each owner would enter into the agreement and fund it using life insurance. At the passing of an owner or key employee, the estate would be paid by the life insurance policy. In return, this will increase the proportional shares of the surviving interest holders. It would end financial burdens on the individuals involved, as well at the corporation.
Finally, you would have your..
Corporate Cross Purchase Agreement-
This will look striking like the partnership form of these buy-sell agreements that you have already read about before. Each shareholder sets a price and agrees to buy a specified number or a percentage of the deceased shareholders stock at the time of death. This method can typically provide tax savings as well. At Good Life Protection, we always recommend speaking to an accountant as well for tax advice.
We have covered how life insurance can help the funding of buy-sell agreements. What are the key benefits it can provide in the planning process?
The Top 3 ways it could save your business and benefit you and your company
Life insurance for buy-sell agreements is going to keep your company liquid. Regardless of what kind of agreement chosen and regardless of which business type you fall into. It can be very stressful to find ways to pay a deceased’s interest in the company’s estate to settle all debts. Life insurance will solve this problem. No individual party to the agreements or the company will be burdened. The business can continue day to day operations and remain profitable……. well……hopefully.
All you will need is to retrieve the funds filing of the death certificate with the life insurance carrier.
Peace Among the Shareholders or Surviving Parties
This directly ties into reason number one, but it is very important. The financial burden a death could impose on a business is the fear of the unknown. Without proper planning, it may be hard to know who is going to pick up the tab of the estate or how the business will even survive after the death. With everything detailed and planned of time, you avoid this pitfall.
If structured correctly, your life insurance will not be subject to estate tax or death tax. The way to do so would be a good fit for an estate planning attorney. Long story short is, taxes are never in the favor of the business. Life Insurance can be a unique tool to save on taxes while providing the funds to pay estate taxes on the deceased interest owner. Typically, you will have to set up a sound structured trust to take full advantage of this perk. Nonetheless, it is one of the few remaining ways to save some dollars up front on the tax bill.
Funding an ILIT (Irrevocable Life Insurance Trust) is the primary avenue to take if considering structuring a sound tax savings vehicle and taking care of a buy sell-agreement at the same time. Talk about business planning at its best. Always kill two birds with one stone when possible.
So now that you have a baseline understanding of some of the options, let’s take a dive into how some of this may look with life insurance carriers.
We always recommend using an independent agent with a variety of life insurance carriers at their disposal. At Good Life Protection, we represent all the top carriers and strive to get you the peak results for the cheapest amount possible.
Let’s say you are a business owner Age 30- The rates displayed will be for a Male Age 30- Preferred Rates and Non-Tobacco User.
As you can see, it is not all that expensive to cover your business you have worked so hard to create. For protection and future headaches, it seems as if it’s a no-brainer.
Since we covered only a 30-year-old male in the previous example, let’s look at a 50-year-old male looking to do the same scenario.
So, it is easy to see that regardless of age, it is still an affordable option to keep your business running smoothly. The goal is the sooner the better. With many companies at an agent’s disposal, you can provide your business with a sound blanket of financial security.
To wrap things up, we want to stress the importance of considering the avenues discussed as a financial planning technique to protect your business. Good Life Protection has personally helped many business owners such as yourself, secure life insurance policies. We piece together a properly planned Buy-Sell Agreements and Life Insurance as we want to help you as well.
Without proper planning, you never know when disaster may strike and it is best to be prepared for the uncertain. Years of hard work should not be negated by a simple planning mistake that is easily avoidable. Good Life Protection would love to hear from you about your individual and unique needs. Give us a call today!