Entrepreneurship is the engine to America’s economy. Collectively, the 28 million small businesses across the U.S. employ more than 50 percent of the working population and have generated 65 percent of net new jobs in the past two decades.
These statistics signify the glory to be had in starting a business. But any entrepreneur will tell you that being a business owner comes with a long list of responsibilities that, at times, can seem never-ending. Often lost in the mix of tasks and to-do items is life insurance, which is more vital than most business owners realize. And we’re not just talking about your personal coverage—that protects your family, but what about your business?
Did you know that you use life insurance as a means of safeguarding your business from the financial effects of a partner in the business dying unexpectedly? We frequently help owners of all-sized companies to insure and protect the future of their business with a buy-sell agreement.
Quick Article Guide
1. What is a Buy-Sell Agreement?
2. Why is a Buy-Sell Agreement So Important?
3. Do All Owners Need to Be Insured?
4. How Do I Determine The Amount of Life Insurance Needed for My Buy-Sell Agreement?
5. What Information Do I Need to Get Started?
6. Buy-Sell Agreement with Life Insurance Example
7. Additional Key Person Life Insurance
8. JRC is Here to Help You
A buy-sell agreement is a legally binding contract between two or more business owners outlining how the assets and equity in a business will be divided if an owner dies. The agreement is created by purchasing life insurance policies for each owner. The business pays for the monthly premiums and is always both the beneficiary and the owner of each buy-sell life insurance policy.
When a business owner dies, their buy-sell life insurance policy provides funds to pay their surviving family for their share of the business. This allows the business to continue operating, without liquidating or selling assets to pay the deceased owner’s family. It also keeps the owner’s families out of the business.
In addition to helping your business continue to operate smoothly, a buy-sell agreement creates a stream of tax-free cash that is paid to the surviving spouse. This money can be used as income replacement for their family, or for any other purposes, such as paying off their mortgage or funding their children’s college education.
You may also be able to reduce your business’ tax liabilities by funding a buy-sell agreement with life insurance. To determine whether this is a possibility, we recommend consulting a tax professional who is familiar with your state’s tax laws.
Without a buy-sell agreement, a deceased business owner’s shares of the business go to their heirs. That spells chaos for businesses with two or more partners, because if one partner dies, the deceased owner’s spouse or child becomes a legal owner of the business.
A buy-sell agreement eliminates this type of situation by acting as a stock redemption mechanism. In a buy-sell agreement, partners or stockholders buy life insurance equal to the respective shares of the other stockholders. The premiums are paid by the company, and if a stockholder dies, the death benefit is used by the surviving stockholders to “buy out” the shares belonging to the deceased’s heir(s).
Essentially, the money is paid to the heir to remove them from the business, as they likely lack the credentials, experience, and capability to step in. Likewise, the grief from losing their family member can create a situation in which latching onto the business becomes more emotional than rational. A buy-sell agreement facilitates a smooth sale in which the deceased’s family is compensated, and the business is positioned to move forward appropriately.
The most important thing to note here is that in order for a buy-sell agreement to be valid, all stockholders must be insured and included, thus it’s a group decision that everyone must agree to and follow through with.
If one of your owners has health issues that you believe may prevent them from qualifying for life insurance, call an independent agent like JRC. There are certain life insurance companies that provide more lenient underwriting for buy-sell life insurance applications. They are more willing to take on a higher risk for one client if it means earning the business of the other business partners as well. Captive agents at big-box companies do not have access to these companies, as they are only able to sell through their employer.
Life insurance is designed not to add value to your business, but to preserve it. An insurance company’s underwriter will analyze the value of your business to determine how much coverage is available for the owners. In the meantime, there are a few ways you can determine beforehand roughly how much each owner can expect to qualify for.
The Book Value of your business is calculated similarly to an individual’s net worth. Business liabilities are subtracted from assets.
The Market Value of your business is the value that a buyer is willing to pay for it, often based on “comps”. If there is a discrepancy between Book Value and Market Value, the nod usually goes to Market Value, as this figure is typically higher and minimizes the risk of being underinsured.
Capitalization of Earnings can also be used to determine the life insurer’s estimated value of your business. This formula is commonly used for service-based businesses because it relies on annual earnings and forecasted future earnings. No value is attributed to physical assets such as buildings and equipment.
Insurers will require some basic information to start the process of creating a buy-sell agreement with life insurance. In addition to the standard, free in-home/in-office life insurance health screening, you will provide:
A Copy of Your Company’s Buy-Sell Agreement:
A business attorney will help you set up your partners’ buy-sell agreement, which includes the method used to determine the value of your business (Book Value, Market Value, or Capitalization of Earnings). You will probably be asked to provide a balance sheet and income statement. In some circumstances, a copy of the previous year’s tax return will be required.
Name of Each Owner and Percentage of Business Owned
This information is required to clearly outline the business’ legal owners and their ownership percentages, which in turn determines the amount of life insurance to be purchased for each person. Some insurance carriers require this information in the initial application stage, while others will accept it later on during underwriting.
Proof That All Partners Are Insured for the Correct Amount of Coverage
If your business partners are applying at the same time, JRC will coordinate this step for you. Typically, the same general policy information is required for each partner, including his or her policy number (if already approved), coverage amount, named beneficiaries, and listed policy owner. You will also be asked if any other life insurance applications are in progress.
In 2015, we worked with the owners of a business worth approximately $10 million, owned by three partners. One partner owned 50 percent of the business, while the other two partners owned 25 percent each.
To effectively “buy out” each partner in the event of an unforeseen death, the primary business owner purchased a $5 million dollar policy, and the other two partners purchased policy for $2.5 million each.
If any of the partners die in the next 10 years, their ownership in the company will be paid out to their family, allowing them to realize their loved one’s equity and maintain the lifestyle they helped to build, with no loss of income.
The business would also be able to continue operating without selling off assets or obtaining a loan to pay off the deceased partner’s share of the business.
While sorting out your buy-sell agreement, there is also the possibility that you will want to buy separate key person life insurance (again, in addition to your personal coverage). Key person coverage protects your business from:
- The business income loss caused by the sudden death of an employee with specialized skills
- The time and resources needed to interview potential replacements
- The time and resources needed to hire and train the chosen replacement
Learn more about key person life insurance here.
When it comes to establishing a buy-sell agreement with life insurance, a big part of our job is to help streamline the application and approval process so that you can focus on running your business.
We will shop 40+ top life insurance companies on your behalf to ensure that each of your owners is properly insured at the best rate available.
If you’re ready to begin finalizing a buy-sell agreement, or if you just want some preliminary information to help you figure out the first steps, don’t hesitate to give us a call at 855-247-9555.
We provide expert consultancy, accurate quotes, and creative solutions to any challenges you may have. We will also ensure that your final policies are flexible, so you can easily cancel one if an owner leaves the firm. Having worked with many business owners across the country, we understand and account for all of your concerns!
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