Insurance for Businesses Series: Buy-Sell Agreement

Successful business owners need ways to protect their companies, compete for top talent, reward employees and plan for a financially secure future. An excellent financial planner understands these needs and know the various roles insurance play in these situations. This is the first one of a 5-part series dedicated to businesses and the role of life insurance in solving some of the concerns of business owners.

Buy-Sell Agreement (for those with business partners)

Succession planning is important to every business because it helps ensure an orderly transition if a shareholder, owner or business partner would retire, become disabled or pass away. If one of these triggering events occurs, a buy-sell agreement is a binding contract governing what happens to an owner’s or shareholder’s business interest. It should have the terms and valuation methodology for a buyout of their business interest. And because life insurance has unique advantages, such as immediate cash available to purchase a deceased owner’s interest, it’s an excellent choice for funding a buy-sell agreement.

The first step is to have a knowledgeable attorney draft the buy-sell agreement. Then, it should be fully executed as soon as possible. Afterwards, an independent life insurance advisor should find the product and carrier best suited for the clients' unique circumstances.

Why should a buy-sell agreement be executed before the insurance is in place? Did I tell you the story of the two BFFs who turned business partners? When one of the partners died, the insurance company paid the surviving partner $1 million. The widow was expecting the surviving partner to buy her out and give her money for the business share of her deceased spouse. Instead, the surviving partner kept all of the $1 million to himself. Naturally, a lawsuit followed. The courts ruled in favor of the surviving partner because there was no properly executed buy-sell agreement. The documents were never signed.

A good buy-sell agreement:

• Is one that is properly signed.
• Protects the continuation of the business with little interruption for employees, customers and creditors.
• Protects the financial security of the owner and his/her heirs in the event of death, disability or retirement.
• Establishes the method for valuing the business and identifying the purchaser(s) of the business interest. It also creates a ready market for the sale of the business interest.

Estate Planning & Gift Tax

I will have a separate blog about estate planning but it is worth mentioning here that a business valuation, as long as it meets certain requirements, may establish the value of the business interest for estate tax purposes. Additionally, it is good to know if the the deceased owner's estate might be eligible for certain potential tax relief provisions. Last but not the least, if any portion of the business interest is to be gifted, the value has to be available for gift tax purposes.

In the event of premature death, buy-sell agreements can be funded or satisfied by one of the following:

• Using life insurance proceeds to pay the surviving spouse or family
• Taking funds out of the business to pay the surviving spouse or family
• Using owners own cash/savings/investments to pay the surviving spouse or family
• Taking a commercial loan to pay the surviving spouse or family
• Give the surviving spouse or family a note – aka promise of future benefit to the survivor
• Allowing the spouse or child to take the deceased partner's place in the company

Which one would you choose?

Life Insurance Strategies for Buy-Sell Agreements

There are generally 3 types of buy-sell plans: Cross-Purchase, Entity Purchase and Wait & See Plans. Let's talk about how life insurance work with these plans. First, is the Cross-Purchase Plan. In this design, each owner has an agreement that their business interest will be exchanged directly with other owners or identified buyers. At the death of an owner, life insurance proceeds paid directly to the surviving owner will provide an immediate source of liquidity to allow for the purchase of shares from the deceased owner’s estate.

Next, is the Stock Redemption Plan or Entity Purchase Plan. In this design, each owner enters into an agreement with the business for the sale of their respective interests in the business. As part of this agreement, the business will purchase separate life insurance contracts on the owners’ lives. The business pays the premiums and will be the owner and beneficiary of the life insurance.

Last, is the Wait & See Plan. This is different from the let's wait and see - don't do anything plan (that one is not advisable)! This plan provides the flexibility to use either a cross purchase or entity purchase strategy upon an owner's death.

Failure to plan is a costly mistake.

Without proper advanced planning, the death of a business owner can result in many costly consequences such as: fire sale of the business assets, lost of primary source of income for the surviving family, demand by creditors for debt settlement and possible need to liquidate estate assets to pay business debts.

As you can see, a properly executed buy-sell agreement facilitates an efficient transfer of business interests, helps assure business continuity as well as help the owners receive a fair price for the business. Business owners with fully executed and funded buy-sell agreement feel confident when they retire as well as feel that they have prepared well for their family's financial security in the event of unforeseen circumstances.

Life insurance has unique advantages, such as immediate cash available to purchase a deceased owner’s interest, therefore it is an excellent choice for funding a buy-sell agreement.

Next time you are working with a business owner, make sure to bring this matter to their attention. As their financial planner, you need to help them have that peace of mind that they have a proper succession plan in place.

If you are a fee-only planner, advisor or a client and would like to know more about this topic, please email me at peachie@peachinsurance.net or if you found this to be helpful, go ahead and share it with your friends using the links below.