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Buy-Sell Agreements: A Business Necessity That Must Be Funded/Insured

What is a Buy-Sell Agreement?

In the simplest terms, it is an agreement between business owners on buying and selling the business. There are many nuances to a buy-sell agreement. If your buy-sell agreement is not set up properly it could end up causing a lot of grief to your fellow business partners, their family and your family members. Therefore, buy-sell arrangements should be structured by an experienced business law attorney in conjunction with all interest holding parties input and review.

The first step of implementing a buy-sell agreement funded with life insurance is to consult with an experienced business law attorney who can structure your arrangement. The size of your business will typically determine the level of difficulty of properly structuring your buy-sell arrangement.  The next step, or simultaneous step, would be to begin the process of obtaining life insurance for the buy-sell agreement. The reason you want to move on obtaining insurance right away is because the approval process can take time depending on the policies and the health of proposed insureds.

Funding Buy-Sell Agreements

Depending on the type of business, and the buy sell agreement terms and conditions, same determines how the insurance proceeds are utilized. Life insurance in buy-sell agreements for corporations, partnerships and sole proprietorships using entity purchase agreements or cross purchase agreements is often utilized. There are other agreements available, not regularly utilized, such as Trusted Cross Purchase, Wait-and-See Buy Sell, and No-Sell Buy-Sell.

In a partnership, typically the two co-owners will get insured and name one another as the owner of each others policy. When a buy-sell agreement is funded with life insurance, the policy owner uses the insurance proceeds to purchase the business interest of the deceased owner’s interest at a predetermined amount. This type of buy sell agreement is called an Entity Purchase Agreement or Stock Redemption Agreement. The benefit here is that it provides the family of the deceased owner with cash instead of non-marketable company stock. The remaining owner is then freed up to carry on the business without the deceased owner’s family getting involved in the affairs of the business. Further, this protects the business from being dissolved upon the death of a co-owner. Finally, the business has a quick influx of liquid income (i.e. cash) that may also be used by any remaining co-owners if the business is in need of liquidity.

For larger businesses with more than two or three owners, such as an LLC, C-Corp, or S-Corp, a different buy sell strategy called a cross purchase agreement, can be effectively implemented. This buy sell agreement strategy requires the insurance to be taken out on all the business owners and makes the business both the owner of the policy and the beneficiary. This way all money flows back into the business to be used as necessary by the remaining business owners, as the remaining owners use the cash to “buy out” the deceased business owner’s interest. Consultation with your tax professional for potential tax ramifications to the business from this strategy is integral to the process as well.

In a sole proprietorship, typically the business will not continue when the sole owner dies. The main issue is that any heir of the business owner is not knowledgeable of the business and the nuances associated with the continuation of the business. Therefore, the buy-sell agreement funded with life insurance, typically in the form of key person business life insurance, will be able to provide liquid assets to the deceased owner’s family as they wait on an appropriate suitor to purchase the business. This strategy also helps avoid “fire sales” where the business is sold for pennies on the dollar due to the need to liquidate assets to wrap up the deceased owner’s business and estate.

One last note for a business owner who also is the primary bread winner of the household: you should get insured as soon as possible. If you are the main income earner, then regardless if you have a buy-sell in place or not, life insurance should still be at the top of your list as a business owner simply because it means your family will be protected financially when you die. Please don’t put off getting at least some life insurance in place as you continue to make strides to grow your business.

Long Term Care Life Insurance

If a partner or co-owner of the business does not die, but instead is diagnosed chronically ill, or suffers form a severe cognitive disorder, such as due to stroke or Alzheimer’s Disease, a buy sell funded with long term care insurance rider may provide the resources needed to fulfill the terms of the buy sell agreement. A chronic illness accelerated benefit rider in a buy sell agreement requires that the condition be permanent. If there is a chance of the partner or co-owner recovering, he or she may not qualify for the chronic illness rider.  A terminal illness rider is also an option to provide for the buy sell agreement. However, the rider requires the insured be diagnosed as terminally ill with 12 months or less to live.

Finally, life insurance with long term care rider provides either a cash indemnity benefit or reimbursement. Ideally, the cash indemnity policy would be the most beneficial but you would need to make sure the buy sell was structured properly and with the correct company that understood your insurance goals and objectives. With a long term care rider, the insured does not have to be diagnosed as no potential for recovery. For example, if the partner suffered a stroke, but showed positive signs that a recovery were possible, they still may qualify, whereas under a chronic illness benefit, the company may refuse.

Disability Income Insurance

Most business owners have never considered using long term disability insurance in a buy-sell agreement as protection if a forced buy-out due to disability occurs. You have a much greater chance of being disabled before age 65 than dying. Yet the majority of buy-sell agreements do not consider the impacts of one of the business owners or key persons becoming disabled.

Here is what happens. You and your business partner are making things happen, growing the business, finding much success, when out of nowhere your business partner has a health issue or injury that puts him or her out of commission. Now, the business is suffering because they cannot do the work load they previously had. They still expect the same compensation from the business, despite the reality that your business is in trouble. The buy-sell agreement funded with disability income insurance policy will address a business owner becoming disabled where the insurer will pay a benefit amount to the beneficiary, the other business owner(s) who is not disabled to be used as a buy-out. This is very effective, particularly when total disability is involved. Some factors that are considered by the provider are the type of business you are in, the benefit amount, the benefit period (monthly or lump sum), the elimination period, the definition of total disability, etc.

Another option business owners should consider is business overhead expense insurance. If you or a business partner, even a key person, should become disabled, the BOE insurance provides income to pay business expenses, until you recover, the key person is replaced, or the business is sold.

In summary, the advantages of a buy-sell agreement properly funded with life insurance:
  • Business continuity by providing remaining owners with cash to purchase deceased owner’s shares.
  • Provide income for deceased owner’s family in case of death or disability.
  • In a partnership, prevents members of the deceased owner’s family from becoming business partners.
  • Provides fast access to liquid assets to protect against “fire sales” of the business, to pay creditors, and to essentially “buy” time for the business to wrap up or be sold.
  • The death benefit from life insurance proceeds is typically income tax free.
  • Enhance credit risk because a succession plan is in place.
  • Using an Irrevocable Life Insurance Trust may be beneficial.
  • Life insurance with long term care rider or chronic illness rider if co-owner is diagnosed as chronically ill or with a severe cognitive disorder, and consider high limit long term disability insurance for use in a buy-sell agreement if one of the business partners becomes disabled.
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