Buy-sell planning for business owners doesn’t have to be complicated. The primary purpose of a buy-sell agreement is to protect the business owners from the financial fallout that occurs after major life events, such as disability, retirement, divorce or a lifetime sale.
A buy-sell agreement is critical to protect each of the business owners’ interests, especially in the event of death. The first step is to select the type of agreement that best suits a given company’s needs. The next step is to identify the business owners’ personal objectives and understand their finances. The last step is to fund the buy-sell agreement with life insurance.
The type of agreement selected will determine who or what will own the life insurance. Buy-sell agreements also can be set up to allow the business owners to accumulate funds in a tax-deferred permanent life insurance policy. But selecting the proper agreement and determining whether the owners or some other entity should own the life insurance policies becomes more complicated. This article explains how to simplify the process and meet each business owner’s objectives.
There are three primary forms of buy-sell agreements:
1. A cross purchase agreement specifies that in the event of a death, the surviving owners purchase a pro rata portion of the deceased owner’s share of the business from his or her estate. To fund the purchase, each stockholder owns, pays the premiums for and is the beneficiary of a specific dollar amount of life insurance on each of the other owners.
2. An entity redemption agreement is between the business and its owners and obligates the business to purchase the interest of the deceased owner. To fund the purchase, the corporation or partnership owns, pays the premiums for and is the beneficiary of the life insurance on each business owner. The amount of coverage depends on the value of the company and the percentage held by each owner.
3. A partnership buy-sell agreement establishes a partnership that owns life insurance policies on each owner. It also pays the premiums and is the beneficiary of those policies. This agreement must be funded by permanent and variable life insurance to establish a valid business purpose for the buy-sell partnership if it has no other business purpose.
Corporate structure obstacles
If the business owners want to accumulate funds in permanent life insurance policies, any one of the three types of agreements might work, but it would be complicated. One potentially complicating factor is the structure of the business. Corporations have several disadvantages in these agreements:
• The cash value accumulation and the death benefit of the life insurance may affect the corporate alternative minimum tax.
• If a death benefit is paid into a C corporation but not used to purchase a deceased owner’s share of the business, distribution of the benefit will be considered taxable income for the remaining owners.
• If a C or an S corporation distributes or cashes out the life insurance policy, any gains will be recognized by either the C corporation or the shareholders of the S corporation. That means a retiring shareholder who takes possession of his or her coverage triggers a taxable transfer of ownership.
The complexities of partnerships
An entity redemption for a partnership is more effective because there is no alternative minimum tax on partnerships. Also, distributions of partnership property typically have the potential to defer income taxation, meaning distributing the life insurance policy to a retiring partner does not destroy the tax-deferred gain. Some partnerships, however, are complex. And if the partnership holds only life insurance, it must be permanent variable life insurance.
Another drawback with the entity redemption agreement applies to cash value accumulation for retirement. Under that scenario, each business owner must agree to the overall investment approach for the funds within the variable life insurance policies. It can be difficult to persuade business owners to agree on one approach, especially if their ages and situations vary significantly.
When an entity redemption is not a viable option, a cross purchase agreement might be an alternative. But it can be cumbersome if there are several people involved. For example, if there are four business owners, they would each have to purchase life insurance policies on each of the other three owners for a total of 12 policies. Also, an owner who retires and wants to collect his or her accumulated benefits will trigger a taxable event and forfeit the tax-deferred gain in the policy.
A simple but effective solution
Instead of trying to fit a round peg in a square hole, take a path of least resistance. Keep it simple and recommend a basic entity redemption or cross purchase agreement with term life insurance.
Tell the business owners to keep this part of the agreement as inexpensive as possible. (They like hearing “inexpensive as possible.”) This leaves the advisor free to work with the owners individually on accumulation. Each of them could have a permanent life insurance policy for their death benefit protection needs as well as an optional source for supplemental retirement funds that they can invest according to their own risk profile. They also have the option of making separate plans for wealth accumulation. They must keep in mind that policy loans and withdrawals may create an adverse tax result in the event of a lapse or policy surrender and will reduce both the cash value and death benefit.
This basic entity redemption or cross purchase agreement with term life insurance often is overlooked possibly because it is so simple. But simple sells — especially when the client gets the desired result.
Robert F. Ebert, CLTC, is a financial advisor and registered representative at North Star Resource Group in Minneapolis. He helps motivated families and business owners identify and achieve their financial goals.
William P. Stark, J.D., LL.M., CLU, is Senior Advanced Marketing Counsel at Securian Financial Group in St. Paul, Minn. Bill assists advisors with business, estate and retirement strategies. He writes advanced marketing material, teaches advanced marketing schools and visits firms to present materials and products. He also develops executive compensation, business planning and estate planning strategies.
This information should not be considered as tax or legal advice. Clients should consult their tax or legal advisor regarding their own tax or legal situation. Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender periods. Variable life insurance products contain fees, such as management fees, fund expenses, distribution fees and mortality and expense charges. The variable investment options are subject to market risk, including loss of principal.
You should consider the investment objectives, risks, charges and expenses of a portfolio and the variable insurance product carefully before investing. The portfolio and variable insurance product prospectuses contain this and other information. You may obtain a copy of the prospectus from your representative. Please read the prospectuses carefully before investing.