Life insurance is designed to help protect a household from the financial hardships that may follow the untimely death of a primary wage earner.
But how will a death affect a small business?
One way of safeguarding a business is to create a buy-sell agreement. A buy-sell agreement is a contract between different entities within a corporation to buy out the interests of a deceased or disabled member. A buy-sell agreement also can protect the business from loss of revenue and cover the expense of finding and training a replacement.
Types of Buy-Sell Agreements
There are two main types of buy-sell agreements:
Cross-Purchase Agreement. A cross-purchase agreement provides owners or key employees the opportunity to buy the ownership interest of a deceased or disabled owner/key employee. Every owner/key employee takes out a policy on each of the other owners/key employees. Cross-purchase agreements tend to be used in smaller companies where there are not too many owners or key employees to cover.
Stock-Redemption Agreement. Stock-redemption agreements are formal agreements between all the owners/key employees – and the business itself – under which the business agrees to purchase the stock of the deceased owner/key employee. Owner/Key employees agree to sell their shares to the company often in exchange for a cash value.
These agreements establish a market value for the owner’s or key employee’s share of the company.
Using Life Insurance to Fund a Buy-Sell Agreement
Life Insurance. Purchasing a life or disability policy in order to fund a buy-sell agreement is an option when preparing for the future. Using life insurance enables a buy-sell agreement to be funded with premium payments and attempts to ensure that funds will be available when they are needed.
When using life insurance to find a buy-sell agreement, each owner must take out a life insurance policy, naming other owners/key members, or the company itself, as the beneficiary. In the event of an owner, the life insurance policy will pay a death benefit to the named beneficiaries. These funds are often paid to the surviving family members, or estate, to purchase the deceased’s interest in the business. This strategy helps to ensure business continuity through a smoother sale of the owner’s ownership interest.
The company itself may pay the cost of the life insurance on each owner. The premiums are not tax deductible for the company, nor are they considered taxable income for the individual members.
Several factors will affect the cost and availability of life insurance, including age, health, and the type and amount of insurance purchased. Life insurance policies have expenses, including mortality and other charges. If a policy is surrendered prematurely, the policyholder also may pay surrender charges and have income tax implications. You should consider determining whether you are insurable before implementing a strategy involving life insurance. Any guarantees associated with a policy are dependent on the ability of the issuing insurance company to continue making claim payments.
Other Methods of Funding a Buy-Sell Agreement
There are other options for funding a buy-sell agreement:
Set Aside Funds. Money for a buy-sell agreement can be set aside, as long as it is easily accessible. These funds must be kept up for the life of the company and may present a temptation during fiscally tough times. The business owners must determine the appropriate amount needed to cover the cost of a buy-out.
Borrow the Needed Amount. A company can borrow enough to buy out a withdrawing owner at the time of their death. However, the loss of the employee can often affect a company’s ability to secure a loan, and the payments become an added stress on the business during an already difficult time.
Why a Buy-Sell Agreement is Important. A buy-sell agreement creates a plan for business stability through the orderly transfer of any ownership interest. When an owner dies or becomes disabled their ownership interest must be purchased by the remaining owners or the business itself. Funding a buy-sell agreement through life insurance can provide the surviving owners with a plan and the needed liquidity to purchase the deceased owners business interest from the surviving family members.