Funding Buy-Sell Agreements With Life Insurance

Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

You bet your life: buy-sell agreements can be funded with life insurance. This lesson will explain how a buy-sell agreement can be funded, and describe the benefits and drawbacks.

Buy-Sell Agreements

Let's say you start a coffee roasting business with a friend. But what if your partner died in a car accident or something? How would you be able to continue the business?

It may sound morbid, but it could be a good idea to plan ahead. In order to ensure the business continues in the unfortunate passing of either of you, you create a buy-sell agreement. A buy and sell agreement is an arrangement used to allocate an owner's share of the business in the case of death, disability, retirement, or a willingness to sell. Sometimes these are called buyout agreements.

To fund it, you each take out a life insurance policy on the other person. This ensures that funds are available to buy out the deceased partner's portion of the business. In other words, if your partner passes away, the proceeds can be used to fund the transfer of their interest to the you.

Closed corporations, partnerships, and sole proprietorships can make use of a buy-sell agreement to allocate business ownership.

A predetermined formula is used to figure out the portion of the business that is re-allocated.

How To Setup a Buy-Sell Agreement

Make sure to fully fund the agreement! The total amount of life insurance coverage should be enough to cover the value of the share of ownership. If your partner's share is $150,000, then that is the amount of insurance you need to purchase to cover them.

There are three key methods for funding a buy-sell agreement with life insurance:

  1. entity purchase
  2. cross purchase
  3. hybrid (wait and see)

Entity Purchase

You can use the business itself (the entity) to take out life insurance on the owners and pay the premiums. This is an entity purchase agreement. In this agreement, it is the business that is the owner and beneficiary for each policy.

Cross Purchase

A cross purchase agreement is an arrangement where each co-owner takes out life insurance on the other co-owner(s). They pay the premiums. If you have more than two co-owners, this means multiple policies are purchased, each co-owner for every other co-owner.

Hybrid

The hybrid, or wait and see agreement is a combination of the above agreements. The entity/business can still take out policies on each co-owner, but the individuals can also purchase life insurance for the others.

Once you've decided on a method for funding, there are a few more considerations for purchase.

Advantages to Funding With Life Insurance

Using life insurance to fund a buy-sell agreement is a low-risk option: For the most part, life insurance rates are fairly low; term life insurance can be purchased at reasonable rates. Whole life policies can be used. Term life insurance is cheaper, but should be used if the business would be dissolved through selling, and not the death of a co-owner.

Should a co-owner pass away, the life insurance proceeds are NOT taxed. The deceased partner didn't own the policy, and so the money does not count against their estate.

That said, there are disadvantages to using life insurance to fund a buy-sell agreement.

Disadvantages to Funding

There are a few disadvantages to funding: These include tax implications, insurability, and valuation of the business.

Taxes, Taxes, Taxes

The premiums are paid after tax. These are not usually a tax-deductible expense (unlike a voluntary insurance benefit offered to employees).

Also, if you cancel a policy (surrender), gains from the policy are subject to income tax. This scenario can occur in a buyout: your co-owner needs to step aside for some reason.

Insurability

There is a real possibility that one of the co-owners becomes un-insurable, either due to illness or age. If there is a large age gap between co-owners, the younger owners will wind up paying higher premiums because they are covering the older individual.

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