Funding Buy-Sell Agreements with Life Insurance
Suppose you are part owner of a firm that has been your family’s primary source of income. Have you ever considered what would happen if you were suddenly diagnosed with a serious medical condition? Naturally, your family’s first concern would be for your health and well being; however, if you were to die prematurely, such an event could affect your family’s financial future. For instance, what would happen to your interest in the business? Would your family find a ready buyer for your share of the company? If your partners were to buy out your share, would they have the necessary cash at their disposal? What price would they pay? In the midst of normal daily business activity, it is often difficult for business owners to find time to address these questions. Yet, once an event occurs, it may be too late.
Protecting Your Family’s Future
How can you prepare for this possibility? A buy-sell agreement funded with life insurance may be one strategy to consider. A buy-sell agreement is a legal contract that prearranges a buyer for your share of the business and stipulates the price that buyer will pay. You may negotiate a buy-sell agreement with your partners, shareholders, members of your management team, or key employees who may have an interest in the company’s future ownership. The deal may be funded with a life insurance policy on your life.
Buy-sell agreements are generally structured in one of two ways: as a cross-purchase agreement or an entity purchase agreement. A cross-purchase agreement is negotiated between you and each partner or shareholder. Upon your death, the parties to the agreement would purchase your shares at a previously agreed upon price with the life insurance proceeds funding the purchase. A cross-purchase agreement generally works best in companies with only two or three owners. As the number of owners increases, it can become expensive and administratively cumbersome for each owner to have a life insurance policy and a cross-purchase agreement with every other owner.
For a company with a larger number of owners, an entity purchase agreement may be more practical. An entity purchase agreement is negotiated between the company and each shareholder. The company purchases a life insurance policy on each shareholder’s life. This reduces the administrative overhead associated with managing multiple buy-sell agreements and life insurance policies—a difficulty inherent in cross-purchase agreements. However, with an entity purchase agreement, it is important to note that because the company owns the life insurance policies, the accumulated cash value may be vulnerable to corporate creditors.
Factoring Tax Considerations
Apart from cost and administrative concerns, tax concerns are another factor to consider when deciding between a cross-purchase agreement and an entity purchase agreement. With a cross-purchase agreement, if you were to die, the parties to your agreement would receive a step-up in basis for the shares they would acquire. This occurs because future capital gains on the new shares will be based on the purchase price spelled out in the agreement, not on your original basis. However, an entity purchase agreement does not carry this advantage. Because the company would buy back your shares, each remaining shareholder’s portion of the business will increase in value.
Preparing for Tomorrow
Unfortunately, you can never know what tomorrow will bring. If you are currently operating without a buy-sell agreement in place, consider putting this at the top of your priority list. If an unexpected event should occur, a buy-sell agreement can help ensure your family will be prepared.
When deciding which type of arrangement is best for your situation, be sure to weigh the benefits of the lower cost and administrative ease of an entity purchase agreement against the possible tax advantages of a cross-purchase agreement. Since buy-sell agreements are complex, legal arrangements, it is important to consult your qualified insurance, legal, and tax professionals for advice according to your unique circumstances.
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