Life insurance is every bit as valuable for a business as it is for a family. Just like you wouldn’t leave your family vulnerable to financial distress after you die, you wouldn’t want to have hanging over your head the looming possibility that your business could possibly shut down if an owner dies unexpectedly.
In this article, we’ll explain the anatomy of a popular type of business life insurance called a cross-purchase agreement, outlining the benefits and drawbacks.
Quick Article Guide:
1. What is a Cross-Purchase Agreement?
2. Pros of a Cross-Purchase Agreement
3. Cons of a Cross-Purchase Agreement
4. Determining the Amount of Coverage Available
5. Additional Consideration: Key Person Life Insurance
6. Is a Cross-Purchase Agreement Right for Your Business?
7. How We Can Help You with Your Insurance Needs
Investopedia defines a cross-purchase agreement as follows:
“A document that allows a company’s partners or other shareholders to purchase the interest or shares of a partner who is deceased, incapacitated or retiring. A cross-purchase agreement is used in business continuation planning. The document outlines how the shares can be divided or purchased by the remaining partners, such as a proportional distribution according to each partner’s stake in the company.”
In a cross-purchase agreement, each owner purchases 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, so that they can “buy out” a deceased owner’s interest from their surviving family, and the remaining owners can collectively put their best foot forward.
Sustaining the Business
First and foremost, a cross-purchase agreement provides funds to pay a deceased owner’s surviving family their share of the business.
This allows the business to continue operating without having to liquidate or sell assets. It also enables the surviving family to access the share of the business that has been left behind to them, without actually having to operate the business.
According to an article published by Forbes in 2013, many privately-owned companies go out of business or are forced to file bankruptcy when an owner dies. In addition, many businesses experience a decline in employment and sales for many years after an owner passes away. Having a cross-purchase agreement in place will prevent your business from selling assets that are vital to the business. Cross-purchase agreements also prevent your business from directly paying an income to an owner’s surviving family.
If an owner in a cross-purchase agreement dies, the surviving owner(s) will not have to pay taxes on the money that is paid out to them. The tax-free death benefit maximizes the cash resources available to the business during such a challenging time.
Shielded from Creditors
In addition to being tax-free, life insurance proceeds from a cross-purchase agreement are not subject to creditors’ claims, because the owners of the business are the owners of the policies.
A lender cannot seize money from cross-purchase agreement to fulfill any personal or business debts that you might have. Again, this ensures that your business has the money it needs to continue operating while providing an income to a deceased owner’s surviving family members.
Course of Action
Never underestimate the significance of simply having a plan. Going through the process of applying for life insurance and creating a cross-purchase agreement will help you to establish a continuation plan that benefits the business and a deceased owner’s surviving family.
The balance between business and life is delicate, especially during crises. A cross-purchase agreement helps the business to care for a deceased owner’s surviving family, while the remaining owners turn their focus to realigning the business.
Owner Paid Premiums
Each owner in a cross-purchase agreement purchases a policy on the other owner(s). As such, an owner who is young and healthy could conceivably be stuck paying premiums for an owner who is a smoker and has previously suffered a heart attack. Put simply, this might not seem fair for the healthy owner, considering premiums can be significantly higher for individuals considered by insurers to be “high risk.”
Freedom to use life insurance proceeds for any given purpose is undoubtedly a benefit on paper. However, the risk in real life is that there is nothing preventing a surviving owner from spending a deceased owner’s death benefit irresponsibly. That said, it’s important to create a clear agreement that provides some legal backing for how life insurance proceeds are to be used.
Since each owner in a cross-purchase agreement buys a policy on the other owner(s), things can get complicated in cases with three or more owners. For example, 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.
For this reason, we usually recommend a stock redemption plan for businesses with three or more owners.
An insurance underwriter will analyze the value of your business to determine how much coverage is available to you. In the meantime, there are a few ways you can determine beforehand roughly how much each owner can expect to qualify for. Divide any of these by the number of owners to reach a ballpark face amount for each life insurance policy.
The Book Value of your business is calculated similarly to an individual’s net worth: assets minus liabilities. This formula is usually used by businesses with a lot of physical assets including; property, inventory, and equipment.
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 making this formula ideal for service-based businesses.
Owners aren’t the only personnel who play major roles in your business. In addition to your cross-purchase agreement among owners, there is also the possibility that you will want to buy separate key person life insurance for other “key” employees, such as top salespeople and long-tenured clerical workers. 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
- Profits and clients that could be lost during this transitional period
To learn more about the pros and cons of key person life insurance, please see our guide, ”What is Key Person Life Insurance?”
Depending on the ownership structure of your business, a cross-purchase agreement may be ideal for the owners of your company. As we mentioned earlier, cross-purchase agreements are usually set up for businesses with two owners.
If your business has three or more owners, you probably want to consider setting up a stock redemption buy-sell agreement instead. We’ve created an extensive guide about stock redemption agreements which can be viewed here.
At JRC Insurance Group, our purpose is not to sell you a cross-purchase agreement just for the sake of reaching a daily sales quota, we’re here to help. We are an independent agency, which means we are committed to providing our clients with quality service and personalized attention above all else.
If you have additional questions about buy-sell agreements or if you want to know which type of buy-sell agreement is best for your business, we’re happy to help. Our services are free, and because we don’t work for a specific insurance company, we are also able to shop more than 40 top-rated carriers to find you the best coverage at the best rates.
Let JRC help you secure the life insurance coverage you need to add another layer of protection to your business. Give us a call today, toll free, at 855-247-9555 and one of our experienced agents will be able to provide you with accurate quotes in just a few minutes. You can also request a live free quote online here and in less than a minute you’ll be able compare rates and coverage from over a dozen “A” rated life insurance carriers.
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