When a business's founder dies, the firm loses about 60% of its sales, and jobs are cut by about 17%. Then for two years following the founder’s death the company has a 20% lower chance of survival than its competitors. The key to business survival is exit planning.
Exit planning means the procedures the company will take to survive following your retirement or death. As a business owner, you may be wondering about the financial security of the business and your family if you were to die. A buy-sell agreement funded by life insurance may be the perfect exit plan for you.
You've never heard of buy-sell agreement insurance? Keep reading to learn the benefits and types of this business owner option.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a legal contract between the owners of a business. The contract is similar to a buyout agreement. A buy and sell agreement details what will happen if a co-owner exits the business. This may be due to a voluntary leave, death, or being forced out by other owners.
The agreement gives all owners and their families peace of mind. Everyone knows what happens to the business and each owner's interest in the business if one partner leaves for any reason.
What Is a Buy-Sell Agreement With Life Insurance?
Life insurance provides funding for the buy-sell agreement. The company or its owners purchase life insurance policies for each co-owner. If you are a co-owner of a business and die, the company or other owners receive the death benefits from your policy.
The buy-sell agreement with life insurance includes specific steps following your death. The co-owners receive your life insurance death benefits. Your family receives a cash payment for your interest in the business.
This provides financial security and stability to the company and your family.
Types of Buy-Sell Agreements
When preparing a buy-sell agreement, the structure of the agreement will vary to fit your particular business needs. Your Life insurance advisor will work with you and all business partners.
They will review the different types of insurance available for the business. They may also provide information to meet additional needs on a personal level.
When you create a cross-purchase plan each owner buys life insurance for the other owner(s). Each owner is responsible for paying the premiums of the policy they own and is the beneficiary of the policies they purchase.
When an owner dies, the surviving owner collects the death benefit. They then use those benefits to purchase the deceased owner’s business interest from the family.
For example, if Amy and Alice have joint ownership in a bakery with a value of $500,000, they each purchase a $250,000 life insurance policy on the other. When Alice suddenly dies in a car accident, Amy collects $250,000 in benefits from the life insurance policy she purchased.
Amy then pays Alice’s family $250,000 for her 50% interest in the company. Amy now owns the bakery free and clear in her own name only and continues operating the business on her own.
When establishing this type of contract you want to make sure it specifies that the business co-owner(s) have the first option to purchase a deceased owner’s interest in the business.
If the business has more than 2-3 owners, it becomes more complicated because each person must hold policies on all other owners. In the event of death, each individual owner must purchase just their own insured portion of business interests from the deceased's family.
The benefit of this agreement plan is a quick and easy payout upon the death of a business owner. The downfall is with multiple business owners, there are multiple policies each owner must purchase and fund. If the business increases the number of owners or partners, it may be beneficial to change over to an entity redemption plan.
Entity Redemption Plan
This plan involves each individual owner having their own separate agreement with the business regarding their respective business interests. The business then purchases individual insurance policies against the lives of its owners. The business pays the premiums for those policies.
Under this type of agreement, if an owner dies their share of the company stock passes to the owner’s heirs or estate. The company may then purchase the shares from the family using proceeds from the life insurance policy.
Going back to the bakery, let's say it has three owners, Amy, Alice, and Alexandria. The business has a value of $750,000, with each person owning 1/3 of the business.
The bakery business purchases a $250,000 life insurance policy on each of the three owners. When Alice dies in a car accident, the business collects $250,000 in benefits from the life insurance policy. The bakery pays Alice’s family $250,000 for her share of the business.
Amy and Alexandria are now the only two owners of the business, each with a 50% interest. Because their individual interest in the company now has a higher financial level, this would be a good time for them to schedule an insurance review.
The benefit of this type of agreement is that the business owns the life insurance policies. This means the policy benefits are not subject to reaching the owner's creditors or being included in their estate. If an owner leaves the business, the policies of other owners are not affected as they would be in a cross-purchase buy-sell agreement.
The hybrid plan is a combination of entity redemption and cross-purchase plans. Upon the death of an owner, the business has the first option to purchase the business interest of the deceased equal to the insurance proceeds. If the business declines or there are remaining shares available after their purchase, the other owners or business partners have the option to buy.
Using the bakery situation with Alice and Amy as owners, the business has a $500,000 value. The business purchases $500,000 life insurance policies on Alice and Amy.
When Alice dies in a car accident, the insurance company pays out $500,000 in benefits, $250,000 to the bakery, and $250,000 to Alice’s family. Amy then uses the $250,000 benefit she receives to purchase Alice’s shares of interest from her family. This allows Amy to remain the sole owner of the bakery, and Alice’s family benefits by receiving $500,000 in cash.
Things to Keep In Mind
The insurance and buy-sell agreement contract work in tandem to bring peace of mind to everyone. Things to keep in mind when establishing the contract include:
- The buy-sell agreement needs to be fully funded—each life insurance policy needs to equal the owner's percentage of interest in the business
- If there is a discrepancy between the insurance proceeds and your interest percentage in the business, how is the difference handled?
- If the insurance proceeds exceed your interest portion of the business, does the excess go to the business or your estate?
- If premiums are not paid the insurance will lapse; include a provision for ongoing proof of payment
- How long does each life insurance policy need to be viable?
- Are the policies to be term life insurance or permanent life insurance?
- If an owner is unable to qualify for insurance, what additional funding methods are acceptable?
- Insurance premiums paid by a company for funding a buy-sell agreement are not deductible as a business expense
- Call rights—the business may elect to purchase an owner’s interest for a premium percentage of the fair market value
- Put rights—an owner can demand the business purchase their interest in the business at a percentage of the fair market value
- Right of first refusal—an owner may sell their interest to an outside party only if the existing owners waive their rights to purchase
- Deadlock provisions provide a means of dissolving the business or one partner's interest in the business
Because of changing values as a business grows or declines, it is important to undergo a review of your coverage on a regular basis. The insurance coverage on each owner may need to increase if a business is expanding. If the business is declining in value, it may be advisable to lower the death benefit of the policies.
Cost vs Benefits
One of the key benefits of a buy-sell agreement funded by life insurance is that proceeds are usually paid out quickly. With sufficient cash values on the policies, the funds make it easy for your interest in the business to be purchased whether your withdrawal is due to death, retirement, or disability. Life insurance proceeds are normally free from income tax obligations.
You may wonder about the cost of buy-sell agreement insurance. That will vary depending on the individual policy benefit amount, age of the person being insured, and the health of the insured To learn more about the costs of this policy, contact Hummel Group for more information.
Advice From Your CPA
The importance of small and medium-sized businesses having a buy-sell agreement in place is increasing. More than 30 million privately held businesses in the U.S. have baby-boomer owners transitioning into retirement. Having an agreement in place prior to a business owner leaving helps the process flow easily.
Whenever you are considering a business contract that affects the financial aspect of your business, consult with your accountant. Your CPA will ensure you receive all tax benefits. They will also confirm that the financial contract implications clearly define your intent.
Your buy-sell agreement will include a valuation clause regarding the terms of a buyout and a definition of the business value. This may be referred to as “fair value” or “fair market value.”
These two terms appear to be the same. In the accounting world, they have different implications when determining the value of a business interest.
Fair Market Value
Fair market value is defined in the Revenue Ruling 59-60. The value is the price that will be paid if the property changes hands between a seller and a buyer when neither has any compulsion to sell or buy. The value of the property is based on two willing parties with reasonable knowledge of all relevant facts regarding the property.
There is no common definition for fair value. It is open to a wider interpretation by attorneys, accountants, and the court system.
The American Institute of Certified Public Accountants uses the term for fair value measurements under the Accounting Codification Standard 820. The same fair value term is applied to owner disputes by attorneys and the court system.
A business appraiser may consider the fair market value to imply certain valuation discounts regarding a noncontrolling or minority interest in the business. Those discounts will impact the marketability of a business interest, lowering its value.
To avoid any such pitfalls and future disputes, it is advisable to consult with business appraisers, accountants, and attorneys when drafting a buy-sell agreement. Each professional will advise regarding specific terminology interpretations within the contract.
Review and Preparation of Contract
To avoid problems with the wording and legal standing of the sell-buy agreement, it is advisable to have it reviewed or prepared by an attorney. The payment of legal fees when establishing the agreement may prevent conflict. The contract needs to meet legal contract criteria and have appropriate wording to meet the intent of all owners.
Attorneys are familiar with the legal requirements of a contract, including buy-sell agreements. To be enforceable a contract must stipulate the terms and conditions each party agrees to in exchange for money or other compensation. The elements of a contract include:
- Offer and acceptance—the agreement between the parties
- Capacity and undue influence—those entering into a contract must have the mental and physical ability to do so
- Intention, form, and legality—parties must intend for the contract to have legal consequences
- Terms and conditions—the backbone of the contract administration
- Breach of contract—what happens if a party does not fulfill their contractual obligations
It is advisable that prior to signing the contract be reviewed by an accountant and a business valuation professional to make sure the terminology will be interpreted correctly.
Get a Buy-Sell Agreement Insurance Quote Today
By purchasing buy-sell agreement insurance you are providing a business exit plan that provides financial security to your business and family in the event of an unforeseen death. At Hummel Group we offer both personal and commercial types of insurance in a wide range of niche markets to meet your needs.
We encourage you to get an insurance review and quote now for the different types of insurance you may need. You may also call us at 800-860-1060 with any questions.