Any closely held business organization, like a real estate broker, whether newly created or established, should have a defined business continuation plan to financially accommodate the possibility of an owner or partner dying, retiring, or becoming disabled. The Buy-Sell Agreement will specifically define how the business will continue after a defined catastrophic event such as the death of the owner or partner.
Most real estate firms have several principals or partners who control the ownership shares in the organization. If a principal or partner dies unexpectedly, chances are his or her shares will pass on to the spouse or other family members. Since the surviving family member is likely to have little or no interest in joining the organization, the surviving principals or partners will need to purchase the shares of the organization that was passed on to the surviving family member. Here is where a Buy-Sell Agreement will spell out the steps that must be taken so that the business can move forward.
The Buy-Sell Agreement
A buy-sell agreement, also commonly referred to as a buyout agreement, is a legal contract between co-owners of a business that governs the situation when a co-owner dies, becomes disabled, retires, or is forced to leave the business.
With a Buy-Sell agreement in place, the remaining or succeeding business owner(s) will have specific directions needed to accomplish difficult expected tasks such as:
- Purchase shares of the business from the heirs of a principal
- Establishing a specific value for the business for estate and tax purposes
- Restrict transferability during life and at death, of ownership control and interest
- Declare and define what events can trigger the right or obligation to buy or sell
- Make it possible for employees to purchase the business from the estate of a principal
The most affordable way to provide funds for the transactions that will take place after the death of a principal is to use Life Insurance as the funding method. In most cases, term insurance is the most affordable and appropriate product to use. There are two common methods when using life insurance as the funding vehicle
- Entity Purchase Agreement
This is a succession plan designed for companies with multiple owners. The plan is established by having the company purchase an insurance policy on the lives of each owner for the amount equal to each owner’s defined interest in the company. The company owns and pays the premium for the policies and is the beneficiary of each policy. In the event of the death of an owner, the benefit collected by the company from the insurance policy is used to buy-out the deceased owner’s share of the business from the insured’s estate.
Business owners typically risk a significant amount of capital and invest a significant amount of time to get their organization up and running, but many fail to adopt a plan for continuation when the worse scenario unexpectedly happens. Assuring the continuity of your business is as important to employees as it is for family members. Take the time to learn about Buy-Sell Agreements and how they can easily be funded using affordable term life insurance.
- Cross-Purchase Plan
When using a cross-purchase type of agreement, each partner or principal is required to purchase and own the life insurance on the other partners or principals. The partner or principal would pay the premium and be the beneficiary on each policy purchased on the others.
The death benefit on the policies would equal the to interest each partner or principal has in the organization. When one partner or principal dies. the remaining principals would use the death benefit to purchased the shares of the deceased partner or principal from his or her surviving family members or estate.
The Cross-Purchase plan will likely prove to be overly cumbersome if there are more than two or three partners or principals, so the ownership could elect to use a “trusteed” cross-purchase agreement.
Using a “trusteed” cross-purchase plan allows for the company principals to hire a third-party entity to act as trustee or escrow agent to fulfill the mutual obligations to each other that are created in the cross-purchase agreement.
Which Type of Life Insurance Should Be Used
In cases where the principals are only concerned about the funding of the agreement, it makes financial sense to use Term Insurance as the funding vehicle. Term insurance, which can be purchased with a 30-year term, is the most affordable life insurance product because the mortality rate for this product is much lower than permanent insurance products, especially in cases where the principals to be insured are young and healthy.
Since there are many highly rated insurers competing for business, a 35-year-old male or female can purchase Term insurance for less than $15 per month per $100,000 of death benefit. Term insurance is a very affordable method to fund a Buy-Sell agreement which is the main part of any business continuation plan.
How Much Insurance Should Be Purchased?
Since ownership shares in most organizations are divided using percentages rather than dollar amounts, the principals should consider the value of their shares over time. It’s always better to purchase more insurance if you are unsure what the value of the business will be over time. An experienced and reputable insurance broker will likely be able to help you determine an accurate death benefit for each policy, but in any case, you can simply pocket any overage.
What Are The Tax Considerations?
Although tax considerations should come from your CPA, there are some general considerations that can be answered here:
- All premiums used to fund a buy-sell agreement are not tax deductible.
- The death benefit is received tax-free regardless of who purchased and owns the policy. Unless the death benefit is payable to certain C corporations. The death benefit which is received by the C corp may generate an alternative minimum tax for the corporation. In order for the proceeds to be received tax-free, there can be no exchange for valuable consideration.
- Premiums paid by a business in which the shareholder is the insured person are not considered taxable income to the insured person.
- There is no gift tax liability upon the execution of a buy-sell agreement.
- When implementing a cross-purchase agreement, one should be weary of the transfer for value rule.