Is your business financially braced for the unexpected?
This can be a sobering question for many business owners who are immersed in the daily rush of growing a company. Mortality is never a comfortable topic, but business partners must safeguard what they’ve worked so hard to build. Just like you wouldn’t leave your family vulnerable to financial distress after you die, you wouldn’t want your fellow partner to be forced out of business if you die unexpectedly.
To safeguard against this risk, businesses create a buy-sell agreement to protect their business from the loss an owner. There are two common types of buy-sell agreements; a stock redemption agreement and cross-purchase agreement.
In this article we’ll dissect a stock redemption plan, which is ideal for a business with more than two owners. We’ll explain the pros and cons to this type of agreement, outlining its benefits and drawbacks.
Quick Article Guide:
1. What is a Stock Redemption Plan?
2. Pros of a Stock Redemption Plan
3. Cons of a Stock Redemption Plan
4. Determining the Amount of Coverage Available
5. Potential Add-On: Key Person Life Insurance
6. Is a Stock Redemption Plan Right for your Business?
“A binding agreement that is implemented by the owners of a business to facilitate the orderly transition of a business interest in the event of the death, disability or retirement of a business owner.”
A stock redemption plan is particularly useful for a closely held corporation with more than a few shareholders, or a business more than two owners. Attorneys, realtors, and other professional practices usually choose to go the stock redemption route. With a stock redemption plan, only one life insurance policy is needed for each shareholder or business owner. This is why stock redemption plans are generally favored by businesses with more than two owners.
In a stock redemption plan, partners or stockholders buy life insurance coverage 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.
With a cross purchase buy-sell agreement, each owner purchases a life insurance policy equal to the other owner’s share(s) of the business. If your business has two owners, a cross purchase agreement is relatively simple because only two life insurance policies are needed (Each owner buys a policy on each other). However, if your business has three or more owners, a cross purchase agreement can get confusing.
If your business has three owners and you decide to set up a cross purchase buy-sell agreement, you would need to purchase a total of six life insurance policies. (Each owner would need to purchase two life insurance policies, one for each of the other owners). If your business has four owners, you would need to purchase a total twelve policies, this is why a stock redemption plan is ideally for businesses with multiple owners.
We’ll explain the pros and cons of a stock redemption agreement below.
Sustaining the Business
Most importantly, a stock redemption plan provides tax-free, cash resources to pay a deceased owner’s surviving family for their share of the business. Without extra funds available, a business might otherwise have to liquidate or sell assets in order to stay afloat during such a challenging time. A stock redemption plan helps the business to continue operating, while also enabling the surviving family to access the share of the business that has been left behind to them (without actually having to operate the business).
Contrary to cross-purchase agreements, which are typically paid for by the business owners themselves, stock redemption life insurance is funded by the company, to provide funds for the company. The business is the owner and the beneficiary of the policy, giving the entity full legal backing in regards to how a life insurance payout would be used.
Equal Premium Split
One of the major drawbacks in a cross-purchase agreement is that an owner who is young and healthy could conceivably be stuck paying premiums for an owner who is in poor health. With a stock redemption plan, the cost is split between the owners based on shares, so no one is making unjustifiably high payments.
Course of Action
Sometimes having a plan in place is what matters most. When you complete the process of applying for life insurance and creating a stock redemption plan, you are preparing your business for the unexpected death of an owner and establishing a “carry on” plan that benefits the business and a deceased owner’s surviving family.
When crises arise, it can be difficult to tactfully balance business and life. A stock redemption plan allows the business to care for a deceased owner’s surviving family, while the remaining owners continue to operate the business.
Subject to Creditors’ Claims
Unfortunately, since the life insurance in a stock redemption plan is funded by the business, the proceeds are viewed as company assets, making them subject to creditors’ claims. This means that lenders can seize money from a life insurance payout in order to fulfill any debts your business might have.
There are also some potential tax obligations relating to stock redemption. If an owner dies, the remaining owners don’t get the benefit of an increase in basis when the corporation purchases the deceased owner’s interest. Stock redemption plans are also sometimes more vulnerable to higher capital gains taxes on estates due to IRS questioning. Be sure to address these potential issues with your life insurance agent and your tax professional.
Thinking of writing off your life insurance payments as business expenses? Don’t do it. Although you have the option to designate your premiums as expenses, doing so will make the proceeds taxable. Being taxed on a life insurance payout can significantly decrease the money your business receives.
How do you know the amount of coverage to purchase? An insurance underwriter will analyze the value of your business, but beforehand, you can get a general understanding of how much life insurance will be available to your business in one of three ways. Whichever you choose, divide the total by the number of owners to reach a ballpark face amount for each life insurance policy.
The Book Value of your business is equal to assets minus liabilities, similar to an individual’s net worth. This valuation method is ideal for businesses with lots of physical assets, not service-based businesses like attorneys.
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 decision usually goes to Market Value, as this figure will likely be higher, thus reducing 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 valuation method ideal for service-based businesses.
Aside from owners, most businesses have other “key” employees that they rely on heavily. In addition to your cross-purchase agreement among owners, consider buying separate key person life insurance for top salespeople, executives, 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
- Any profits that may be lost during the transitional period
Learn more about key person life insurance here.
As an independent life insurance agency, JRC’s sole mission is to help individuals and businesses find the right life insurance for their needs. We have no desire or reason to sell you a stock redemption plan if, after an evaluation, it becomes clear the drawbacks for your particular situation outweigh the benefits.
That said, we have helped many businesses create a customized, cost-effective stock redemption plan. Our agency is owner-operated and we’re licensed to sell life insurance in 49 states and DC. And since we don’t work for a specific insurance company, we are able to shop more than 40 top-rated carriers to find you the best coverage at the best rate. In fact, we can routinely save our clients more than 30% on the cost of their life insurance coverage.
Let JRC help you add another layer of financial protection to your business, whether it’s through a stock redemption plan or a cross-purchase agreement.
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