Building a successful business can be one of life’s most satisfying experiences. You’ve created an asset for your family, while providing livelihoods for your employees to provide for their families.
But what happens if you or your business partner dies?
Life insurance for buy-sell agreements is the most common protector.
This 10-minute overview will cover the basics and help you determine if it’s something for you and your business partners to consider.
Quick Article Guide
- How a Buy-Sell Life Insurance Agreement is Used
- Cross-Purchase Buy-Sell Option
- Stock Redemption Plan Option
- Agreement Structure and Taxation
- Policy Cost and Salary Disparity
- Determining How Much Coverage to Obtain
- Additional Purposes for Business Life Insurance
A buy-sell agreement is designed to protect a business, the owners and their heirs if one of the owners were to die unexpectedly. Basically, this agreement protects the fundamental continuity of the business for the remaining owner(s) by buying out the deceased owner’s share from their heirs.
This is done by each owner of the corporation purchasing a life insurance policy on the other shareholders or owners of the company.
One version, called a “cross-purchase buy-sell agreement” is the most popular buy-sell life insurance structure for a small corporation with no more than four owners.
Reason being, a cross-purchase agreement requires each owner to buy an individual policy on each of their partners. The amount of life insurance is equal to their respective share of the net worth of the business. A corporation with just four owners would need a total of 12 life insurance policies, each owner would buy a policy on the other three partners (3 x 4 = 12).
Not to say you shouldn’t implement a cross-purchase agreement if your company has more than four owners, but be prepared for many life insurance applications in your company’s near future. It can easily become a messy and complicated affair.
Each owner will be beneficiary, payor, and owner of each policy they purchase on the lives of the other business owners. It provides a clear outline of how the deceased owner’s heirs will sell their interest to the remaining owner(s) with the insurance proceeds. One of the benefits of this type of buy/sell agreement, is the family of the deceased owner’s tax basis will be equal to the fair market value at time date of death, making for favorable tax treatment on the death proceeds.
A stock redemption plan is another popular option worth considering. This agreement is ideal for a closely held corporation with more than a few shareholders.
The shareholders of the corporation enforce limitations on the transferability of stock held by each party of the agreement. In a stock redemption plan, the business purchases individual life insurance policies on each of the owners.
When a shareholder suddenly dies, the corporation buys the deceased owner’s share from their heirs with the life insurance proceeds (at a previously agreed upon price). The deceased owner’s heirs receive immediate liquidity at fair market value for their business interest.
The two distinct benefits of stock redemption plans over cross-purchase agreements are:
- Stock redemption plans are easier to manage when there are multiple partners since only one policy per owner is needed.
- The corporation bears the inequality of life insurance premiums due to varying owner’s gender, age, health, lifestyle, etc.
The business pays the premiums, is the policy owner, and is the beneficiary on each of the policies in a stock redemption plan.
It’s important to note that stock redemption plans are more at risk to estate taxes due to IRS traditionally questioning the undervaluation of the stock by the closely held corporation.
The most apparent disadvantage of stock redemption plan is that the remaining owners don’t get the benefit of a step-up in basis when the corporation purchases the deceased owner’s interest.
Basically, this translates to stock redemption plans being more vulnerable to higher capital gains taxes than cross-purchase agreements if their share is sold prior to their death. Therefore, estate tax consequences should be discussed with your tax professional before executing a stock redemption plan to protect your business.
Buy-sell agreement structure and taxation considerations vary state to state. You will generally utilize the rules of the state where your business owners reside. Advise us if your business reside in different states.
This Investopedia article provides a helpful overview of Structure & Taxation considerations.
Life insurance companies have specific departments to assist with buy-sell life insurance. We work with their team and underwriters to provide a check-list of items needed by your finance, tax and legal advisors.
How do businesses handle the insurance cost inequality? There may an unfair disparity with premiums due to each owner’s age and health. A young owner may be responsible to pay hefty premiums for an older owner with current or previous health complications.
Many corporations resolve this simply by adjusting salaries, or stock vesting schedule, or initiating a “bonus” to make up for the life insurance premium inequality.
Still, it may be impossible to completely rectify due to individual marginal tax rates being affected by higher salaries. As always, consult your tax professional about the tax consequences for each owner to see if executing a cross-purchase buy-sell agreement is right for your corporation.
When setting up a buy-sell agreement for your business, how much coverage should you buy on each owner? The amount of coverage purchased on each business owner is determined by the owner’s share of the business, and the overall value of the business itself.
When determining the value of a business, there are 3 common methods that life insurance companies will accept when approving your policies.
1. Book Value: The book value of a business is calculated just like the net worth of an individual. With this method, add up the sum of the liabilities or debt that the business has, and subtract this amount from the assets the business owns.
The book value of your business is determined by financial accounting, and is generally the better choice for businesses with a lot of fixed assets like land, buildings, and equipment.
2. Market Value: The market value of a business is whatever a purchaser is willing to pay for your business. In some cases the market value of a business is higher than the book value because the book value is what you paid for an asset, not what the asset is worth today. The market value on the other hand is what someone is willing to pay you for that asset.
An example of this might be a commercial building. If your business purchased a building for $250,000 a few years ago, but the building recently appraised at $350,000, the market value is $100,000 more. You can learn more about the difference between book value and market value here.
3. Capitalization of Earnings: The capitalization of earnings for a business is determined by a business’ average annual net income or revenue.
This method is generally more favorable for start-up companies, or service-based businesses, that do not have a large amount of fixed assets like property.
Once you determine the value of your business, you can easily determine how much life insurance to purchase for each owner.
For example: Let’s say your business is worth $1,400,000 and there are 3 owners, simply divide the value of your business by 3 (about $466,000 each).
If each owner represents a different ownership percentage of the business, they should purchase the amount of insurance that is equal to their ownership share.
In the example above, if the business is worth $1,400,000 and one of the 3 owners represents a 20% share of ownership, their life insurance policy should be $280,000 or 20% of the total value of the business.
If your not sure where to begin, give us a call at 855-247-9555, we’re happy to assist, and we’ve helped hundreds of business owners with their buy-sell agreements.
ING Life Insurance for Buy-Sell Guides
ING has created one of the better life insurance for buy-sell agreements guides. I often review it clients by phone. It offers some good illustrations, and we can identify which of the 26 pages are appropriate and to focus on. Otherwise it’s a little overwhelming. If you’re so inclined, the New York Society of CPAs has published a guide to buy-sell life insurance agreements. It’s written by CPAs for CPAs, so is a bit dry, buy also covers the topic well from an accountants perspective.
In addition to buy-sell agreements, businesses use life insurance for additional purposes such as:
- Insuring a Key Employee
- Employee Retention
- Group Life Plans
Please read our “Beyond Key Person” article for more on these related topics.
JRC Insurance Group offers extensive knowledge and experience in helping business owners secure life insurance to fund buy-sell agreements. We have over 45 highly-rated carriers at our disposal, so regardless of your health or other risk factors, we’ll match each owner to their most affordable A-rated life insurance company.
Our services are provided free of charge. We are compensated by whichever insurance carrier you choose.
Call JRC today, at 855-247-9555, to see how we can make this important business decision an easy solution at the most competitive rates in the life insurance market. Get a free quote here.