How small business owners can use life insurance to fund a buy-sell agreement
My firm, Lasting Wealth Principles, does not sell any insurance products, but I still believe that life insurance is a particularly important wealth protection tool, especially for small business owners. Deciding on the type and amount of life insurance to purchase depends on an individual’s specific financial situation and goals. As I go through both the insurance and estate planning parts of my financial planning process with small business owner clients, I evaluate whether a buy-sell agreement is applicable (e.g., shared ownership of business with one or more people) for them and if life insurance is the most efficient way to fund it. The purpose of a buy-sell agreement is to provide instructions on what the owners will want to happen with the business if an owner exits the business (e.g., death, disability, or retirement). Using life insurance to fund a buy-sell agreement provides a smooth transition of ownership and financial security in the event of a death.
Cross-Purchase Agreement
One of the more common buy-sell agreements used by small business owners is a cross-purchase agreement where each owner will purchase a life insurance policy on the life of the other owner(s). In the event of an owner dying, the surviving owner(s) are contractually obligated to use the life insurance proceeds to purchase the deceased owner’s share of the business from their estate. Take the hypothetical example below to illustrate how life insurance is the funding mechanism for this type of agreement.
Mark and James are equal owners of a technology consulting business (valued at $2 million). Due to their hard work over the years and knowing the distinct challenges of running this type of business, they would prefer not to have any of their heirs operating the business in the event of one of them dying. Mark decides to discuss this concern with his financial planner who recommends that he and James structure a cross-purchase agreement, which would make one of them 100% owner of the business if the other person dies. James agrees. First, Mark and James meet with an attorney to structure the desired terms of the agreement. Subsequently, they both purchase $1 million life insurance policies on each other (with Mark being James’ 100% primary beneficiary and James being Mark’s 100% primary beneficiary).
So, in the event of Mark or James dying, two steps would occur:
The surviving business owner obtains $1 million (50% of the business value) as the primary beneficiary of the life insurance policy.
Per their cross-purchase agreement, the surviving business owner is required to use the $1 million from the life insurance policy to purchase the deceased owner's 50% ownership from their heirs.
Not only would the surviving business owner keep full control of the business (with none of the deceased owner's heirs involved), but the heirs of the deceased owner would get the appropriate monetary value (from the deceased owner’s estate).
Entity-Purchase Agreement
Another type of buy-sell agreement that can be used by small business owners is an entity-purchase agreement where the business entity purchases life insurance policies on the lives of each owner. If an owner dies, the business entity (as the 100% primary beneficiary of each policy) is contractually obligated to use the life insurance proceeds to purchase the deceased owner’s share of the business from their estate.
Other considerations
The deceased owner’s estate and surviving owners should consider tax implications associated with these types of buy-sell agreements. Although life insurance proceeds are generally income tax-free, there could still be estate tax implications depending on the size of the deceased owner’s estate and specific state tax laws.
Given the complexity of tax laws and regulations, I think it is important for all parties involved in a buy-sell agreement to consult with a tax professional, such as a Certified Public Accountant (CPA), Enrolled Agent (EA), or tax attorney who has the expertise to help a small business owner understand the tax implications of these types of transactions.
It is also prudent to periodically review buy-sell agreements that have been put in place to address the potential change in the circumstances of the business, which could include changes in ownership and/or business valuation. Making sure the business valuation is up-to-date and accurate ensures that the heirs of a deceased owner would get the appropriate monetary value (from the deceased owner’s estate). For example, if a business of two equal co-owners is valued at $1 million, then each owner’s insurance policy would have a death benefit of $500k, but if the business significantly grew in value over many years to $4 million, then each policy’s death benefit would be $2 million instead. Note that increasing life insurance coverage could require additional underwriting requirements, which might be an issue if the life insurance company does not provide a favorable offer (i.e., lower premium to pay).