Being a small-business owner is rewarding, but it’s not easy. You work extremely hard to ensure your business stays successful.
Getting your business up and continuing to run is one aspect of being a small-business owner, another is protecting its future. Whether you’re a start-up in the early stages or have been successful for years, there are risks you need to mitigate and life insurance is an important financial tool for your business.
Life Insurance for Buy-Sell Agreements
What is a buy-sell agreement?
A buy-sell agreement is a written legal contract that details the plans for how a deceased business owner’s interest in the business will be sold to a purchaser. The sale price is prearranged and documented in the agreement.
There are three parties involved with a buy-sell agreement. You have the business owner, the person or entity agreeing to buy the owner’s interest in the business (this is often a co-owner), and the business owner’s heirs.
A buy-sell is necessary to protect your business and family should you die unexpectedly. Without a plan, what happens to your share in the company?
If you’re the sole owner, this means without proper planning your business essentially ceases to operate. If you’re in a partnership, this means without proper planning your share of the business goes to your heirs who may not have an interest in the business or just may not be the best fit to take over.
The Goals of Those Involved
The surviving business owners want to be able to keep running the business without interruptions or interference from the deceased owner’s heirs. They do not want any third parties coming in and taking over the business they’ve dedicated many years to.
Surviving business owners also want to be able to purchase the deceased owner’s share of the business quickly and at a fair price. They also want to preserve the loyalty and support of all the employees, customers, and creditors during this difficult time.
The deceased owner’s heirs want ongoing financial security after the loss of their loved one. They either want to retain their rightful share of the business or receive a fair price for their business interests. And they want a prompt settlement of their loved one’s estate.
Business owners want to make sure that their business and family are both taken care of should they die unexpectedly. They do not want there to be any conflict or litigation between the surviving business owners and their loved ones.
A buy-sell agreement can help:
- Increase the ability of a business to prosper after major life events;
- Preserve ownership control;
- Provide continuity of management;
- Convert unmarketable stock into cash;
- Establish a fair and reasonable price for the business;
- Help fix the value of the deceased’s interest for federal estate tax purposes.
Types of Buy-Sell Agreements
There are three main types of buy-sell agreements:
- One-Way Buy-Sell Agreements
- Cross-Purchase Buy-Sell Agreements
- Entity-Purchase Buy-Sell Agreements
One-Way Buy-Sell Agreements
A one-way buy-sell agreement occurs when there is a sole owner of a business. There are no co-owners to naturally take over if the owner dies.
Many sole-owner businesses don’t outlast their owners due to a lack of succession planning. A one-way buy-sell agreement can help ensure the business’s future success.
How does a one-way buy-sell agreement work?
In a one-way buy-sell agreement, the sole owner commits to sell, and the purchaser commits to buy the business interest if a specific event occurs. This event is typically the owner’s death. The purchaser, ideally, is one of the business’s employees.
The purchase price is pre-determined and defined in the agreement. The price is either determined by a fixed price, which should be re-evaluated from time to time, or a formula specified in the agreement. The purchaser buys a life insurance policy on the business owner’s life in the amount equal to the purchase price. Upon the business owner’s death, the purchaser buys the owner’s share from the estate.
If the business owner ever wants to sell the business during his or her lifetime, the purchaser named in the buy-sell agreement has a “right of first refusal”. This means the business owner must first offer to sell the business to the named purchaser prior to attempting to sell it to a third-party. Only after the named purchaser declines the offer can the owner pursue a third-party sale.
Cross-Purchase Buy-Sell Agreements
A cross-purchase buy-sell agreement is a contract between business owners in which all owners commit to purchasing the business interest of another owner if a certain event occurs, typically death. This type of buy-sell works well for businesses with two to three owners who are all relatively close in age.
How does a cross-purchase buy-sell agreement work?
With a cross-purchase buy-sell agreement, each business owner agrees to buy a portion of a deceased owner’s business interest. To fund this, each owner buys a life insurance policy on the life of every other owner. The coverage amount of each policy in total should equal the total purchase price for that owner’s share of the business.
Example of a Cross-Purchase Buy-Sell
John, Sue, and Joe own equal shares in a business valued at $3,000,000. Therefore, each of their shares is worth $1,000,000.
John purchases a $500,000 life insurance policy on Sue and a $500,000 life insurance policy on Joe.
Sue purchases a $500,000 life insurance policy on John and a $500,000 life insurance policy on Joe.
Joe purchases a $500,000 life insurance policy on John and a $500,000 life insurance policy on Sue.
Each owner is insured with a total of $1,000,000, their share of the business. If an owner dies, each of the surviving owners uses the $500,000 death benefit to purchase the total $1,000,000 share from the deceased owner’s estate.
It’s advisable to use cross-purchase agreements when the owners are relatively the same age. This is because the life insurance premiums insuring a young person are vastly different than they would be on an older person. It wouldn’t be fair if a 35-year-old co-owner was paying policy premiums on a 65-year-old co-owner.
In addition, a cross-purchase agreement is best if there are only a few owners involved. With the example above, there are six total life insurance policies for three owners. Imagine if the company had six owners. Then there would be a total of 30 life insurance policies since each owner needs to own a policy on every single other owner. This can get quite complex and a lot to manage.
For businesses that have a wide disparity of owner ages or multiple owners, an entity-purchase buy-sell agreement would be best.
Entity-Purchase Buy-Sell Agreements
An entity-purchase buy-sell agreement is ideal if there are many business owners or if the owners’ ages are vastly different.
How does an entity-purchase buy-sell agreement work?
With an entity-purchase buy-sell, the business entity agrees to buy a deceased owner’s interest from the deceased’s owner’s estate for a pre-determined price.
The business needs each owner’s consent to purchase a life insurance policy on their life. The insurance coverage amount should equal the purchase price for that owner’s share of the business.
The business also has access to the policies’ cash values in an entity-purchase buy-sell agreement. Typically with the cross-purchase and one-way buy-sells, this isn’t allowed.
Funding a Buy-Sell with Life Insurance
A buy-sell agreement needs to be funded in order to work. Life insurance is often the most effective means of funding this sale.
Which type of life insurance should be used?
There is no general answer as to which type of life insurance is best in a buy-sell scenario. It depends on several factors in the business planning situation.
Term life insurance may be more appropriate if:
- The buy-sell agreement is expected to end by age 65 or 70.
- Low annual premiums in the early years are important.
Permanent life insurance may be more appropriate if:
- The buy-sell requires funds for disability or retirement scenarios.
- The insurance is needed as a source of liquidity or collateral for the business.
Benefits of Using Life Insurance to Fund a Buy-Sell:
- Life insurance creates a lump sum of cash to fund the buy-sell agreement at death;
- Life insurance proceeds are usually paid quickly after your death, ensuring that the buy-sell transaction can be settled quickly;
- Life insurance proceeds are usually income tax free;
- If sufficient cash values have built up within the policies, the funds can be accessed to purchase an owner’s interest following retirement or disability.
Benefits to the Policy Owners:
- Cash becomes available at the business owner’s death to help meet purchase obligations created by the buy-sell agreement.
- Gives assurance to a valued key employee or family member that their loyalty and dedication are recognized and that their role in the business will continue.
- Access to policy cash values, if any, to use should the purchase of an owner’s interest happen pre-death.
Benefits to the Insureds:
- Cash is available for estate liquidity or other family needs.
- The departing owner and his or her heirs are relieved of business responsibilities.
Buy-sell agreements are extremely important so it’s smart to hire an experienced attorney to draft these contracts to make sure everything is structured properly.
Life Insurance for Business Succession
Growing a business is no small feat. Deciding what happens when you’re no longer in charge is another challenge to tackle.
You may have a spouse and children, but what happens if some of them don’t want to be a part of the family business? How do you ensure your business will fall into good hands and leave an inheritance to those who rather work at something else?
» Learn more: Life Insurance for Business Succession Planning
Case Study: John’s Family Business
John Smith owns a successful business. He is married and has two children. His wife, Jane, has been instrumental in the success of the business, but she does not want to be dependent on it as her primary source of income after John’s death. Their older son, Ethan, shares his father’s love for the business, but their younger son, Henry, has decided to become a physical therapist.
John’s and Jane’s goals are to:
- Ensure Jane will be financially secure.
- Leave the business to Ethan.
- Make the inheritances of the two sons equal.
Whether John dies first or Jane, issues are set to emerge. If John is the first to die and leaves Jane the use of all of their assets, Jane would have a business that she does not want, and Ethan would not own a business that he does want.
The issue of equalization really comes into play when Jane passes away. If Jane leaves the business to Ethan, there will not be sufficient assets for an inheritance for Henry. If she divides the estate equally between them, Ethan will have a partner who is not interested in the business and therefore likely won’t be much help in continuing its success.
To complicate the matter further, once the estate passes to children and not to a spouse, it may be subject to estate taxes. So, another issue arises. From whose inheritance will these expenses be paid?
If these expenses are paid from the business, there likely would be no business. If they are paid from non-business assets, Henry would end up with little or no portion of the estate. If the expenses are divided equally between the two of them—which is the likely event—this could cause the ending of the business, the liquidation of family assets and possibly their home.
Using Life Insurance to Equally Divide Inheritance
In the case study above, the desire is to pass the business to Ethan when his father dies and to make the inheritance to each son equal. Life insurance can be used to help achieve these goals. A buy-sell agreement funded with enough life insurance can enable Ethan to purchase the business from his father’s estate.
How this works:
At John’s death, Ethan uses the life insurance proceeds to purchase the business from John’s estate. Ethan then owns the business and the estate has cash to help equalize the inheritance to Henry.
Key Person Life Insurance
Who is a key person?
As a business owner, do you have an employee who would directly affect business operations if that person suddenly didn’t show up for work again?
This person might work in:
- Operations – keeping the work efficiently flowing from onboarding to satisfied customer for the entire company.
- Partnerships – knowing key players in your industry and building your business partnerships.
- Profitability – watching and managing the financials to ensure you stay afloat.
This individual is your business’s key person.
Many times this person’s deep relationships is what drives business through the door. If this person were to die unexpectedly, problems for the company may arise such as:
- Loss of skill and experience
- Disruption of revenue stream
- Loss of reputation and recruiting power
- Management and staff disruption
- Contractual benefits due to employee contracts
The costs associated with losing a key person can be tangible as well as intangible. Your organization could lose profits generated by the special talents or contacts of the key employee.
Finding a replacement to step in is usually a slow and expensive process.
Many companies have no other employees with the same knowledge, experience, judgment, or reputation as the deceased key person. Less qualified employees must fill in and their lack of experience could impact your bottom line.
To find a permanent replacement for this key person takes time whether you fill the position from inside or outside the company.
Filling the position from inside means that the understudy’s duties must continue to be performed while the vacated position is being filled.
Additionally, there is a learning curve when training a new person and the company must absorb the cost of getting this person up to speed as hiring from the outside may be even more time consuming and costly.
Sometimes an employer is contractually obligated to pay salary and/or provide benefits to the family, even if the employee cannot perform their work due to death. This situation also may cause your bottom line to take a hit.
What is key person life insurance?
Key person life insurance is exactly what it sounds like. It’s insurance coverage on the life of a key person of a business.
The amount of life insurance you can buy on a key person depends on their “value”.
There are many approaches to valuing a key person. These can range from:
- Multiple of salary
- Loss of value to the business
- Cost to replace the key person’s sales profits
- Cost to replace the key person’s contributions to income
Key person valuation can be tricky and working with a professional risk manager may be helpful.
How does key person life insurance work?
A business (the policy owner) takes a life insurance policy out on the key person (the insured) naming the business as the beneficiary. If the key person passes away, the business will file a claim with the insurance company to receive the death benefit which is generally not subject to income tax.
In order for a business to receive death benefits tax-free from an employer-owned life insurance (EOLI) policy, an employer must comply with Notice and Consent requirements before a policy’s effective date, meet one of five conditions, and file IRS Form 8925 every year policies are in effect.
To meet the Notice and Consent requirements an employer must notify the insured in writing of the amount of life insurance being issued and that the employer will be both the policyowner and the beneficiary. The insured must also consent to:
- Being insured,
- Allowing the policy to continue after employment ends,
- Letting the employer be the beneficiary.
IRC Section 101(j) requires one of these conditions be met:
- At the time the contract was issued, the insured employee was a director or highly compensated employee
- The insured employee is among the highest paid 35% of all employees
- The insured was an employee of the employer within the 12 months immediately preceding their death
- The death benefits are payable to the insured employee’s heirs
- The amount is used to buy an equity interest in the employer from the family member, beneficiary, trust, or estate.
These are the steps to key person life insurance, simplified:
- The business obtains the employee’s written consent to the policy.
- The business follows the formalities necessary to approve the purchase of the key employee policy. (For example, if the business is a corporation, the board of directors must authorize the purchase.)
- Business applies for, owns, and is the beneficiary of insurance on the key employee’s life.
- Business pays all premiums and meets all reporting and record-keeping requirements.
- If employee dies, business receives the policy proceeds upon the employee’s death to use as needed to cover losses and find and train a replacement.
Key person protection helps a business through the difficult times and reassures other valued employees, clients, vendors, and prospects that the company’s future is secure.