When you own a business you need to develop procedures that take effect in the event one of the co-owners dies or becomes disabled and unable to work. While key employee insurance provides coverage for the loss, it is different from the exit-plan provisions of a buy-sell agreement with life insurance.
Buy-sell agreement insurance provides financial backing for your buy-sell agreement. It is normal to look at the bottom line regarding the cost vs the benefits. Learn here about the different types of buy-sell agreements, different types of insurance, and their impact on your buy and sell agreement cost.
Buy-Sell Agreement Determines Life Insurance Owner
There are two main types of buy-sell agreements. The type of buy-sell agreement your business has or will develop determines who purchases the life insurance. It also affects the coverage amounts of each policy.
If your company enacts a cross-purchase plan, each owner or partner needs to purchase a life insurance policy on every other owner. When one owner dies, the remaining owners collect as a beneficiary on the life insurance they bought. Those funds are paid to the deceased person's family to buy out their interest in the business.
If you have a company with only one or two other owners, this may be an ideal arrangement for you. The way the agreement works is:
- Amanda, Amy, and Amelia are joint owners of a hair salon that has a value of $200,000
- The owners each own one-third of the business, a business value interest of $66,667
- The buy-sell agreement states that each member will purchase $35,000 life insurance policies on the other two owners
- When Amanda dies in an auto accident, Amy collects $35,000 on the policy she owns and Amelia collects $35,000 on the policy she owns
- Amelia and Amy each pay Amanda’s family $33,333.50, a total of $66,667 for Amanda’s interest in the business
- Amelia and Amy now own the business as partners, each with a 50% interest
The buy-sell agreement designates how the extra $8,333 each collected on the life insurance policies will be used. The use of the overage is agreed upon by all owners when establishing the contract terms.
The agreement may require payment of any excess benefits go to Amanda's family to reduce their financial burden. It may require excess go back into the business to cover loss the business incurs due to Amanda’s absence. It may allow each owner to keep the overage for their own personal gain.
If the company is larger, with several co-owners or partners, this type of policy may be financially cumbersome because of the number of life insurance policies each owner must purchase. That is when an entity or stock redemption plan may be a better choice.
Entity or Stock Redemption Plan
This type of buy-sell agreement includes a clause where each owner or partner agrees to sell their interest in the business upon death. The business is responsible for purchasing life insurance policies for each owner. The business owns and is the beneficiary of those policies.
The business pays the insurance premiums. This eliminates the personal out-of-pocket cost for each owner. When an owner dies, their share of the company passes to their heirs or estate.
The business collects the life insurance benefits on the policy they own. The company then uses that cash to purchase the deceased owner's business interest from the estate.
This benefits the company as they secure ownership of the company. The family receives cash for their interest in the business, providing financial security for their loss.
Using the same example as above, the hair salon Amanda, Amy, and Amelia own purchases one life insurance policy for $70,000 on each owner. When Amanda dies in a car collision, the business collects the $70,000 benefit. The hair salon then pays $66,667 to Amanda’s family or estate as payment for her interest in the business.
The buy-sell agreement will designate how the extra $3,333 in benefits will be distributed or used. While there is less overage in benefit payouts for the company to use, each owner has not made out-of-pocket payments to cover the life insurance of the other co-owners. After the buy-out, Amy and Amelia each own 50% of the business.
Buy and Sell Agreement Insurance Types
Term and whole life are the two types of insurance available for purchase. Most businesses purchase term insurance for their buy-sell agreements.
Term insurance is cheaper, but only covers a set number of years. It is possible to use whole life policies for buy-sell agreements. When using this insurance, the buy-sell agreement usually includes provisions for rolling the insurance over to the insured in the event they leave the company prior to death, such as for retirement.
This type of insurance covers the insured for a set period of time, such as 10-20 years. If you die within the coverage period it will pay out the policy amount to the designated beneficiary.
If you die after the designated period, no benefits are paid. The premiums you paid remain with the insurance company. This insurance is considerably cheaper but offers no dividend benefits because there is no accumulation of cash value.
Whole Life Insurance
When you purchase whole life or permanent life insurance, you receive coverage that lasts your entire life. The insurance comes with an investment account that accrues cash value over time. The premiums are higher but remain the same for as long as you live.
The death benefit is guaranteed and pays out when you die. Your beneficiaries receive both the face value of the policy and the accumulated cash value.
The cash value is an investment account that a portion of your premiums goes into each month. The account continues to grow over time. Once the cash value reaches a certain level, you can borrow against the account.
Additional Cost Factors
Just like personal life insurance, there are numerous factors that impact the cost of each policy bought to fund a buy-sell agreement. This includes the age, health, and habits of the insured. Other factors include whether you purchase term or whole life policies and the death benefit amount.
The average cost is difficult to determine when considering life insurance. Companies usually do not report premium data. This may be to protect information about their policyholders' privacy, which includes information about the insured’s age and health.
When obtaining a quote, it is important to be honest about your life habits. This includes habits such as drinking, smoking, and other high-risk activities.
If you lie to get a lower premium and the insurance company finds out, they may cancel your policy. They may also refuse to pay your death benefit. This is allowable if the coverage is obtained by providing false information.
With a buy-sell agreement, facts relative to the business will also have a bearing on the cost of the insurance.
What Is Your Business Worth?
The value of your business will impact the amount of coverage you purchase for each business owner. A large business with annual revenue of $5 million and five partners will require each partner to have a $1 million life insurance policy. The business pays the premiums and is the beneficiary with an entity or stock redemption agreement.
If the company has a cross-purchase buy-sell agreement each of the five partners will need to purchase four (4) $250,000 policies, one for each of the other four partners. The four policies collectively cover the $1,000,000 interest of each partner.
When putting together your buy-sell agreement, talk to Hummel Group about which method of purchasing policies is most cost-effective. You must also consider the out-of-pocket costs for each partner vs the business owning the policies.
Age and Gender
Women have a longer life expectancy, which lowers the cost of their premiums. The average life expectancy is 79 years for women, 72 years for men. Because of their lower lifespan, men are usually more expensive to insure than women of the same health and age.
At the same time, the older you are when purchasing a policy, the higher the premiums will be. That is because of the increased risk the company may have to pay out the death benefit before they collect a comparable amount of premiums.
If your business has a mixture of ownership in men and women or older and younger people, the cost to insure each individual owner for the same death benefit may vary considerably.
Death Benefit Amount
The cost of your policy premiums will vary depending on the amount of the death benefit. If you have a small company where each owner only needs $50,000 in insurance to cover their interest in the company the premiums will be very reasonable in cost. If the business is larger and each person requires a death benefit of $500,000, the premiums will be higher.
Work You Perform
Even as an owner, the task you undertake at work may have an impact on the cost of your life insurance. If you manage a construction company and are out on the sites or assisting in builds you have a high-risk position. Other high-risk occupations include logging, farming, roofing, and more.
Health of Owners
The health of each business owner has a huge impact on the cost of their buy-sell agreement life insurance. Each owner will likely need to complete a health questionnaire and receive a physical before receiving approval.
Anyone who uses any type of tobacco product will have a higher life insurance premium. Being a regular consumer of alcohol may also likely impact your insurance costs. This is because of the health risks these activities create.
If a person is a risk and unable to receive a standard policy, they may want to inquire about a guaranteed issue policy. This is a policy that does not require you to answer questions about your health or have a medical exam.
People who participate in extreme sports during their free time will likely have a higher cost for life insurance. These are sporting activities with characteristics that include high speeds and high risk. You may be surprised at some of the activities that make this list and can impact your insurance premium costs:
- Freestyle Skiing
- In-Line Roller Skating
- Mountain Biking
- Racing and acrobatic motorcycle and snowmobile competitions
- Zorbing—riding inside of a giant inflatable ball
- Scuba Diving
- White water rafting
- Blobbing—a giant airbag in the middle of a lake you jump onto, causing liftoff
- Alpine skiing and snowboarding
- Wakeboarding and water skiing
This is just a short example of extreme sports that may impact life insurance premiums. There are many activities that we think of as "normal" but they come with a high risk of injury or loss of life.
Get a Review
It is important to contact your insurance provider for a review of your business insurance coverage. Changes in your business value or the death of an owner may increase or decrease the amount of coverage you need.
Whenever your business experiences a significant change in revenue, ownership, or any other area contact Hummel Group to make sure the financial needs of your business are being met.
Is Buy-Sell Agreement Life Insurance Tax Deductible?
The premiums the business or owners purchase to fund a buy-sell agreement are not tax-deductible. The plus is that the death benefits are usually not subject to federal income tax.
There are some instances, such as C corporations, where there are some taxes assessed. The price established in a buy-sell agreement for an owner’s business interest may set the value for federal taxes if proper legal requirements are met. This includes the price being based on a professional appraisal.
The appraisal uses a formula that includes:
- The outlook in the specific industry and general economy
- Prior sales of business interests
- The financial condition of the business
- Company’s assets book value
- Company’s earning history
- Company’s future earning potential
The best way to make sure you meet all your legal tax obligations is to consult with your tax accountant.
Buy-Sell Agreement Insurance: The Bottom Line
Use buy-sell agreement insurance to fund the exit plan for your business in the event an owner dies. This provides peace of mind in what will happen to the business.
It provides the finances necessary for remaining owners to buy out the deceased owner’s business interest. It also gives clear direction on who the remaining owners will be and establishes how the business is valued.
Whether you have not yet set up a buy-sell agreement, have the agreement and need it funded, or need a review on whether your business has sufficient insurance coverage, Hummel Group can help. We will review the coverage you have and make recommendations, including how to improve your risk management. Contact us today at 800-860-1060.