What to Know About Using Life Insurance to Fund Buy-Sell Agreements

A Chief Concern

Navigating a Buy-Sell Agreement

A chief concern among business owners is what will happen upon the death of one of the owners, and how will it affect the business, the other owners and the heirs of the deceased owner. Surviving owners want to ensure the continuity of ownership, and not risk having a large share of ownership fall into the hands of potentially inexperienced heirs of the deceased. In addition, they want to protect themselves and the company financially. On a personal level, owners want to also ensure that their family is financially secure and compensated fairly in case something happens to them.

A buy-sell agreement can address all of these concerns. It is a contract among business owners which, upon the death of one of the owners, requires the remaining owners or the company itself to purchase the deceased’s interest in the company according to the agreed upon terms of the contract. In addition, the deceased’s heirs are required to comply by selling their inherited interest at the previously agreed upon price.

FUNDING A BUY-SELL AGREEMENT

There are various options for funding a buy-sell agreement, but some carry more risks than others. Some owners choose either to save money now and pay cash or to take out a loan to buy out a deceased owner’s share in the company. Both of these situations can be financially risky, both for the surviving owner(s) and the company itself.

The smartest method for funding a buy-sell agreement is through life insurance. This ensures that funds are immediately available when a death occurs; plus, death benefit proceeds are generally income-tax free. In addition, the funds used to buy the deceased’s share are purchased for pennies on the dollar and the premiums will likely be significantly lower than the cost of repaying loan interest.

Types of buy-sell life insurance include the following:

• Cross Purchase Plans: Under this type of plan, the owners enter into an agreement with each other. Each owner purchases a life insurance policy on the other owners, and will be named the beneficiary of the policy. Upon the death of an owner, each surviving owner receives life insurance proceeds income-tax free and uses said proceeds to purchase the deceased’s business interests, while the heirs receive an agreed-upon payment for their business interest.

• Entity Plans: In this type of agreement, also known as a stock redemption plan, the company purchases life insurance policies on each owner, with the company itself as the beneficiary. When an owner dies, the company receives the life insurance proceeds and uses said proceeds to purchase the deceased’s business interest, while the heirs receive an agreed-upon payment for their business interest.