A buy-sell agreement is a legally binding contract used to distribute the share(s) of a business in the event that the owner leaves the business or passes away. Often referred to as a buyout agreement, a business prenup, or a business will, the contract is used by partnerships, sole proprietorships, and closed corporations in order to disburse the share or interest of the partner, proprietor, or shareholder.
Once you have determined that your company needs a buy-sell agreement, you will want to contact your financial professional, as well as your tax and legal advisors in order to determine the most efficient and affordable way to fund the agreement.
There are several strategies used to finance a buy-sell agreement.
- Agreeing to an installment sale – Using corporate income to make installment payments.
- Creation of a sinking fund – Covering the cost of the agreement by withholding business profits and creating an after-tax cash reserve.
- Borrowing – Getting a loan to finance the buy-sell agreement.
While these strategies are credible options, most business owners elect to fund their buy-sell agreement with life insurance.
There are numerous reasons why funding a buy-sell agreement with life insurance makes logical sense for your company. First, upon the death of a company owner, the lump sum of cash from the death benefit within the life insurance policy can be used to fund the purchase obligation in the buy-sell agreement. Most often, the company does not have the funds readily available in order to cover the purchase, even with a sinking fund.
Secondly, once a claim is made, the insurance provider generally distributes the death benefit in a timely manner, granting the buyer an instant source of funds to complete the purchase. Third, for the most part, the premiums remain level, depending on the type of life insurance you purchase, which allows you to fund the buy-sell agreement with a relatively predictable expense.
Finally, the contributions paid toward the life insurance policy are received tax-free because the life insurance premiums are paid with after-tax income. However, if your corporate structure is subject to AMT, consult your tax advisor.
Depending on your needs and goals, there are two types of life insurance you will want to consider to fund buy-sell agreement – Term life insurance and permanent life insurance.
Term Life Insurance
This insurance provides temporary coverage for a certain period of time (term). There is no cash value component, for it only provides death benefit coverage. As a result, the initial premiums for term life insurance will be lower than comparable permanent life insurance coverage.
Term insurance is often a great option for businesses with limited cash flow. The premiums are typically lower and are beneficial for those needing coverage with limited financial resources, such as start-ups or small businesses running on a tight budget. Term insurance is also considered a cost-effective option for businesses with a specific time frame in mind – for example, in order to coordinate the term of the policy with the planned retirement of the principal, or businesses with an intent to sell after so many years.
Many term life insurance policies offer a provision to switch to a permanent policy without the required need for medical underwriting. This arrangement assists in providing start-ups with increased flexibility, affording necessary coverage today with the convenience of building cash value (once converted to a whole life policy) once the business flourishes and greater cash flow is available.
Permanent Life Insurance
This type of life insurance provides lifetime protection, meaning that as long as the premiums are paid, the named beneficiaries will receive the death benefit regardless of how long the insured lives.
Whole life insurance, a type of permanent insurance, provides lifetime coverage with an accumulated guaranteed cash value. Besides providing for the death benefit, this guaranteed cash value feature also provides living benefits.
One such living benefit might include the fact that the cash value of the policy can be utilized to partially fund the buy-sell agreement for an event other than death. Divorce, retirement, disqualification (the loss of a license to practice), or disability are all events that may be covered in the buy-sell agreement. Additionally, the cash value of the policy can be used by way of withdrawal or loan, in order to settle partially, if not all, of the buy-sell agreement when needed.
Depending on the design of your buy-sell agreement, the business may be able to include the policy cash value as a company asset, which can then be accessed in the form of a loan for other business purposes. It is wise to discuss this with an accountant.
Once an owner retires, the ownership of the whole life insurance policy can then be transferred to that retiring individual, which should be the insured. With its guaranteed cash value, the insured is able to use the policy any way they wish. For example, they can name their own beneficiary, and/or supplement their retirement income with the cash value. Consult a tax advisor regarding any possible tax consequences.
Examine Your Choices
Your business was built by making wise choices. Choosing the best method for funding a buy-sell agreement presents another shot at making wise decisions, by basing the needs on yourself, your partner, and your business. Talk with a financial advisor today about your needs and what options are available for you.