The staying power of a business is defined by its ability to overcome challenging times. In the same way people turn to life insurance to protect their families, business owners often seek life insurance to protect what they’ve worked so hard to build.
What would happen if you or a partner in your business died unexpectedly? The scenario is probably somewhat unsettling to visualize, but would your business be able to recover from the loss?
In this article we’ve outlined a few strategies that entrepreneurs can use to protect their business, family, and the employees that rely on them.
Quick Article Guide:
1. What is a Buy-Sell Agreement?
2. For 2 or 3 Business Owners: Cross Purchase Agreement
3. For 3 or More Business Owners: Stock Redemption Plan
4. Why Are Buy-Sell Agreements So Important?
5. Determining the Right Amount of Coverage
6. Bolstering Your Business Coverage with Key Person Life Insurance
7. Your Time is Valuable
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A buy-sell agreement is a life insurance policy that a business purchases for any number of owners. It is a legally binding contract that outlines how the assets and equity in a business will be divided if an owner dies.
In a buy-sell agreement, a separate policy is purchased on each business owner. If a business owner dies, their life insurance policy will provide funds to pay their surviving family for their ownership share of the business.
This allows the business to continue operating by preventing it from being forced to liquidate or sell assets. A buy-sell agreement also keeps the owners’ surviving family members or spouses from being forced to get involved in day-to-day operations.
If one of your business owners is in poor health and has previously been declined for personal life insurance, they might have a better chance of being approved in a buy-sell agreement. Oftentimes, we find that insurers are more willing to accept a “high-risk” applicant when they have a chance to gain the accompanying business of several additional applicants. At JRC, we’ve helped many businesses create a buy-sell agreement even with an owner who is in poor health, simply by writing a “Letter of Explanation.”
Though used as a mechanism for providing a payout to the insured’s family, a buy-sell agreement is not a replacement for personal life insurance. Your business owners should retain or seek their own personal coverage separately.
If you are in business with one other partner, a cross purchase agreement is the type of buy-sell life insurance you will want to go for. Sometimes this type of coverage can work for up to three owners, but definitely no more than that. With a cross purchase agreement, each owner purchases a policy on the other owner(s), and they are listed as the beneficiary and payor of that policy or policies.
Typically these policies are paid for with the owner’s personal funds, not company funds. However, some companies may choose to reimburse the owners, but these reimbursements are not considered to be a deductible expense for the company in the eyes of the IRS.
One major advantage of a cross-purchase agreement is that it protects the death benefit of the life insurance policy from creditors or lenders. However, as we mentioned earlier, each owner is responsible for paying for the cost of the other owner’s life insurance. The potential downside to this is that if you’re younger or healthier than your business partner, you’ll have to pay more to insure them.
Each owner should purchase a life insurance policy on the other owner(s) with a face amount equal to their respective share of the net worth of the business. In addition to protecting the business as a whole and each of the owners, a buy-sell agreement can save the deceased owner’s family thousands of dollars on taxes. Life insurance proceeds are paid out to the beneficiary as a tax-free lump sum.
You can see how a cross purchase agreement would get messy with more than two or three owners, though. A corporation with just four owners would need a total of 12 life insurance policies:
- Owner 1 would need to buy a policy on owners 2, 3, and 4.
- Owner 2 would need to buy a policy on owners 1, 3, and 4.
- Owner 3 would need to buy a policy on owners 1, 2, and 4.
- Owner 4 would need to buy a policy on owners 1, 2, and 3.
That’s a lot of paperwork!
A stock redemption plan is another popular option worth considering, particularly for a closely held corporation with more than a few shareholders. Attorneys, realtors, and other professional practices usually turn to stock redemption for their business life insurance needs.
In a stock redemption plan, 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) at an agreed upon price. The deceased owner’s heir(s) receive immediate liquidity at fair market value for their business interest.
A major benefit of stock redemption plans is that the company is responsible for paying all of the insurance premiums preventing one owner from paying more than another owner with health issues. This also alleviates the financial burden of paying for your business partner(s) insurance premiums each month. With a stock redemption plan, the company is listed as the owner of the life insurance policy, and this may improve your company’s creditworthiness.
The only two drawbacks here are that the remaining owners don’t get the benefit of an increase in basis when the corporation purchases the deceased owner’s interest, and stock redemption plans are sometimes more vulnerable to higher capital gains taxes on estates because of IRS questioning. Be sure to address these potential issues with your life insurance agent and your tax professional.
Put simply, a buy-sell agreement helps to keep the family of a deceased owner out of the business. This is not to alienate them, but to enable them to access the share in the business that has been left behind to them, without actually having to operate the business, since they likely lack the credentials, experience, and capability to do so. Likewise, the grief from losing their family member can create a situation where 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. Businesses without this type of protection in place are often forced to liquidate assets at a fraction of their value and shut down. Without a buy-sell agreement, the death of an owner could also spell chaos for the business if the family decides they want to step in and exercise their ownership in the company.
Pro Tip: Don’t take the option to pay your premiums with pre-tax dollars. When you pay with pre-tax dollars, the life insurance proceeds become taxable, which can greatly diminish the real-life value of your coverage.
When you apply for a cross purchase agreement or stock redemption plan, 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: assets minus liabilities.
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.
A Capitalization of Earnings formula can also be used to determine the life insurer’s estimated value of your business based on annual earnings and forecasted future earnings. No value is attributed to physical assets such as buildings and equipment.
It’s important to reevaluate the value of your business every 3 to 5 years to ensure that your business retains adequate coverage for each owner. If your business has increased in value, you’ll want to purchase supplemental coverage to bridge the gap.
While sorting out your buy-sell agreement, there is also the possibility that you will want to buy separate key person life insurance. Key person insurance covers your business for:
- 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.
It’s great that you’re taking the time to research a buy-sell agreement for your business, but do you realistically have the time to see it all the way through? Most business owners would rather be focusing on other priorities.
Let JRC Insurance Group shop 50+ top life insurance companies on your behalf to ensure that each of your owners is properly insured at the best rate available. We will help you organize the paperwork, weigh your options, and address any potential roadblocks. Don’t jeopardize the future of your business any longer—click the button below to get a free quote today or call us to speak with an expert at 855-247-9555.
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