Understanding how to fund a buy-sell agreement with life insurance is critical for any business owner seeking to ensure the smooth transition of their enterprise.
This guide aims to demystify the process and provide practical advice for effectively integrating life insurance into your business succession plan.
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What Is a Buy-Sell Agreement In Life Insurance
If you are looking into a buy-sell agreement then chances are you are a small business owner. In fact, probably with at least one partner. In some cases, you may have multiple partners.
A Buy-sell agreement that is funded by a life insurance policy or policies is very important business insurance. Unlike purchasing a life insurance policy for a key man, or using it for a deferred compensation plan, it is used for the interests of the partners.
A buy-sell agreement is put in place for the protection of the remaining partner’s interests. Above all, in the event that one of the partners dies, becomes disabled, or leaves the business.
If it is death, the surviving owners will split the ownership of the deceased partner’s share of the business. In fact, life insurance will pay the deceased partner’s family as a buyout. This will then eliminate their ownership or business interests.
How Do Buy-Sell Agreements Work
When you form a business and you have partners every business decision is made by the contributions of each partner. Unless, of course, if there is a silent partner.
When the operating agreement of an LLC is completed, there will be buy-sell provisions a part of it or in a separate agreement. This provision or agreement details what will happen if a triggering event occurs.
This will also detail whether if outside members can purchase the departing members’ interests. In addition, the remaining members can purchase the remaining interest.
Also, if you have stockholders you may have a stock redemption plan in place. We will talk more about that later in this article.
Why Is Buy-Sell Agreement Important
Above all, this is a great question! We will give you specific examples below. But first, let’s discuss why it is so important.
So many circumstances can happen when you have multiple partners or members of a company. The main goal is to make sure the business continuation moves forward in any event.
For instance, if death occurs to one of the members or partners, the percentage ownership of the deceased would go to the family if the buy-sell agreement is not set upright.
This can be good or bad. In most cases, it is bad because the deceased family members don’t know too much about the business and what it takes for it to be successful.
This is why a buy-sell agreement is so important. It protects the business and its remaining partners if any member leaves become disabled, or dies.
Funding Buy-Sell Agreements With Life Insurance
Funding a buy-sell agreement with life insurance will give the partners or members peace of mind knowing if the worst-case scenario happens the company will still move forward.
When considering buy-sell life insurance it is normally a term life insurance policy. This will be the most affordable life insurance and it can be in most cases a tax deduction for the company.
In the event of a partner’s death then the death benefit will buy out the family members and the deceased owner’s share will be split amongst the remaining owners.
It’s important to know when purchasing policies, for this reason, life insurance companies will want a copy of the operating agreement showing ownership. In addition, they will want proof of ALL member’s and partners’ life insurance policies that match up to the percentage ownership of each partner.
In addition, in most cases, these partners also have a disability policy for each partner in the event that they become disabled. This will assist in the income replacement for the disabled.
Life Insurance Buy-Sell Agreement Example
After reading this far you should have an idea of how a buy-sell agreement that is funded by life insurance works.
Again, it is very important to have these taken care of in the right way. It will no doubt spare pain and agony if something were to happen to a partner or member.
Let’s go over some examples of how a buy-sell agreement would work in certain circumstances.
ABC company has been doing great the last few years and profits are just rolling in. Tom, John, and Mike started the company 5 years ago and they had their buy-sell agreement funded with a life insurance policy. In the last year, they had the company valued at 1.5 million. So each owned a share of 33.3% each. So they updated their life insurance policies to reflect that and each had a half-million-dollar life insurance policy. They also each had a disability policy in case they became disabled and were not able to perform their corporate responsibilities.
Example 1 (Death):
John was killed over the weekend by a drunk driver blowing a red light. It was a tragedy and the family and his partners are mourning the loss. After a few weeks, John’s family got a check from the insurance company for $500k. This was the buyout of the value of John’s share of the company. The funding of the buy-sell agreement with life insurance made this possible. John’s family did not have to be owners of the company they really did not know much about. And Tom and Mike split the ownership value and now have 50% each.
Example 2 (Disability):
John was hit by a drunk driver and had severe injuries. He was laid up in the hospital for over a month before he was released. Unfortunately, John will not be able to walk again and lost the use of his right hand, and blind in one eye. He is considered disabled and his daily duties at his company he is no longer going to be able to do. The disability buy-sell policy the owners have enables them to provide cash to purchase the disabled insureds share of the business. Now Tom and Mike split the business 50/50 and John has his share bought out from the buy-sell disability policy.
As you can see, it is very important to have these in place as anything can happen. Life can change in the blink of an eye. It’s always best to be prepared.
Buy Sell Agreement Cross Purchase
Keep in mind, a buy-sell agreement is a legally binding contract. It establishes how the partners or shareholders sell, transfer their interest. In most cases by death, disability or forced to sell.
Under a cross-purchase agreement, the remaining owners agree to purchase the remaining part of the owner’s interest. Including, shareholders or members whether it is from death, disability, or forced removal.
How is the necessary life insurance coverage for a buy-sell agreement determined?
Coverage should be based on the valuation of each owner’s share in the business.
Can the structure of a buy-sell agreement be modified as the business evolves?
Absolutely, agreements should adapt to meet the changing needs of the business.
Are there any tax implications associated with life insurance for buy-sell agreements?
Generally, life insurance proceeds are tax-free, but consulting a tax advisor is recommended for specific situations.
What happens if the life insurance policy isn’t enough to cover the value of the business share?
In cases where the life insurance payout does not fully cover the value of the deceased partner’s share, the agreement should have provisions detailing how to manage the shortfall. This might involve staggered payments, external financing, or adjustments to the agreement terms.
Can a buy-sell agreement with life insurance cover more than death scenarios?
Yes, life insurance for buy-sell agreements can also encompass situations like disability or critical illness. It’s possible to include riders or additional policies that activate in these circumstances, ensuring the agreement remains effective not just in the event of death, but also in cases of long-term incapacity.
Grasping the concept of how to fund a buy-sell agreement with life insurance is indispensable for any business aiming for long-term success and resilience.
This approach not only facilitates a smooth transition of ownership but also provides financial security and reassurance to all parties involved, thereby safeguarding the legacy and future of the business.
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