BUY/SELL PLANNING STRATEGIES
What is a Buy-Sell Agreement?
While business owners hope to be successful enough that they have cash on hand to buy a partner’s interests out after an unexpected death, disability or triggering event (bankruptcy, divorce, resignation, retirement of an owner, etc.), that’s not always the case. Even if it is, a lack of pre-planning can create an unfavorable situation when valuing the business and determining the method of payment.
Buy-sell agreements create a two-pronged approach to ensure the continuation of the business after the death or triggering event of one of the owners. First, these agreements spell out the means by which the business will be valued at the time of an owner’s death. In addition to establishing an easy to define valuation method, they also (when properly structured) provide the funding with which the surviving owner(s) can purchase the deceased owner’s shares, thus allowing business and personal capital to remain untouched. One of the ways that a buy-sell agreement can fund the purchase of the interests is by establishing the purchase of a life insurance policy for each owner. All or a portion of the death benefit is then used to buy out the interest based on the valuation method chosen in the agreement.
Insurance isn’t the only way to fund a buy-sell agreement. Businesses can also choose to fund them with annuities, which may be preferred if one or more of the business owners happen to be uninsurable.
Who Needs a Buy-Sell Agreement?
Businesses with one or more partners should consider implementing and funding a buy-sell agreement immediately at inception of the business. Doing so ensures not only that there is no question of how the business continuation and succession is to be handled upon the death of an owner, but also that the remaining owners will have the liquidity to fulfill the agreement and the business won’t suffer adverse consequences due to funding delays.
Buy-sell agreements don’t just lay out the terms of a purchase and sale under the death of an owner, however. When funded with a permanent life insurance policy, the cash values accumulating in the policy or policies can even be used to fund the agreement in a non-death situation.
A buy-sell agreement isn’t just a positive step for the owners; in the event of one owner’s death, it also serves the best interests of the heirs. Without a funded buy-sell agreement, the heirs would likely inherit the business interests of the deceased owner and may not know what to do with them, or have to wait for a qualified buyer to buy them out and get the liquidity they need. Lastly, while a former partner may have been essential to the business, the heir may interfere and inhibit progress. Excess proceeds of the life insurance can help to secure a valuable replacement for the deceased partner.
How Buy-Sell Agreements Work
The first step in developing a buy-sell agreement is to determine which type of agreement the client wants: Cross Purchase, Stock Redemption or an LLC Buy-Sell.
CROSS PURCHASE AGREEMENTS
With a cross purchase agreement, each of the company owners agrees to purchase life insurance on the others. They personally pay the premiums on each of the policies and are the policy owners and beneficiaries of the coverage they secure.
When an insured owner passes away, the death benefit is immediately paid to the other shareholders who will use the funds to buy the deceased owner’s shares based on the terms of the agreement. If the tax basis of the shares is the same as the valuation for the buy-sell, the heirs receiving the buyout may not have to pay taxes on the income.
Cross purchase plans can be difficult to manage fairly when there are many owners with disparities in premiums brought on by health issues as well as varying ages and smoking classifications.
Also, life insurance policies purchased by individual owners could be subject to personal creditors and may be factored into applicable state taxes and alternative minimum taxes.
STOCK REDEMPTION AGREEMENTS
In this arrangement, the company buys insurance on each owner, rather than the owners buying the various policies on each other. The death benefit is then paid directly to the business upon death of the shareholder. The funds are used to purchase the deceased owner’s shares.
Companies with multiple owners of varying ages and health conditions often favor this method for its fairness and ease of managing. In a redemption, if the deceased owner had a controlling interest in the business, the corporation’s ownership of the insurance policy could be construed as an instance of ownership. This means the death benefit would be considered part of the owner’s estate and, thus, subject to estate taxes.
Policies owned by the business can be subject to claims of company creditors. However, the policies’ cash values can be recorded as an asset on the company’s balance sheet.
Limitations of Traditional Buy-Sell Planning Despite the many benefits of the traditional buy-sell strategies, there remain significant limitations that prevent widespread implementation among many businesses that could greatly benefit from buy-sell planning. Below are a few of the frequently cited limitations of traditional buy-sell planning:
- The cash value and death benefit of the life insurance policies often can be reached by creditors of the business (under a redemption agreement) or creditors of the individual business owners (under a cross-purchase agreement).
- Under a cross-purchase buy-sell agreement, the number of policies required to carry out the plan can become difficult to manage depending on the number of business owners, as each owner must own a policy on the life of each other owner. For example, in a business with three owners, six policies are needed.
- The success of a buy-sell plan can be largely dependent on the responsibility and oversight of the individual owners and the plan can be compromised if the individual owners fail to pay the premiums on their policies or if they refuse to pay over or use the death benefits pursuant to the buy-sell agreement.
- The financial burdens of the premiums may be allocated disproportionately if younger owners have to own policies on older owners, which carry higher premiums and vice versa.
- Undesired income tax consequences can be triggered by the transfer for value rule when remaining policies are transferred between owners, as will be necessary at the death of an owner, as well as other times during the plan.
LLC Buy-Sell Agreement
The Benefits of Using an LLC Buy-Sell A recent advancement in buy-sell planning is the use of a limited liability company (LLC) separate from the underlying principal business entity to own the buy-sell insurance. Under this approach, the business owners would still execute a cross-purchase agreement, but would form an LLC to own a life insurance policy on the life of each owner. Using an LLC to own and administer the insurance policies can combine the benefits of redemption and cross-purchase agreements, while eliminating the disadvantages of both. The use of an LLC can lessen the administrative burden, make use of tax benefits, afford flexibility in structure, and provide numerous other benefits as discussed below.
- Avoids Numerous Policies: Typically, a cross-purchase buy-sell agreement requires each business owner to own a policy on the life of each other business owner. However, by using an LLC to own the buy-sell insurance, the LLC owns all the policies, so only one policy per shareholder is needed.
- Protection from Creditors: In a typical buy-sell agreement situation, if the policy is owned by the principal business entity, the policy may be subject to the creditors of the business. Similarly, if the policies are owned by the business owners in their individual capacities, the policies may be subject to the reach of creditors of the individuals. However, by using a separate LLC whose main purpose is to own the buy-sell insurance, the policies generally are protected from the reach of creditors of the principal business and creditors of the individual business owners. Further, IRS guidance supports the valid business purpose of such an LLC used solely to own insurance.
- Tax Benefits: Typically, in buy-sell planning, unwanted income tax consequences are often triggered as a result of the transfer for value rule under Internal Revenue Code 101 which treats as income any valuable consideration received in exchange for the transfer of any right to receive life insurance proceeds. This situation can arise in numerous scenarios during traditional buy-sell planning. For example, in traditional cross-purchase buy-sell planning, when any owner dies, the surviving owners typically purchase the life insurance policies owned by the deceased owner at his death (which the deceased owner owned on the other owners). This can trigger the transfer for value rule requiring income to be recognized. However, when using the LLC structure the transfer of policies generally is not necessary, and one of the exceptions to the transfer for value rule is the transfer to or from a partnership in which the insured is a partner, so this exception applies when transfers are necessary. Finally, IRS guidance provides that, so long as properly structured, insurance proceeds payable to the LLC would not be includable in the estate of a deceased owner.
- Transferability: The use of an LLC to own buy-sell insurance allows much easier transitions by permitting new owners to join the LLC and participate in the existing insurance framework, while also allowing current owners to exit the LLC prior to death, without triggering the transfer for value rule. At the death of an owner, his or her death benefit is used to buy the deceased owner's interest in the principal entity and to cancel his or her interest in the LLC, eliminating any ongoing obligations.
- Economics: The use of an LLC allows for flexibility in structuring how the premium costs for insurance policies are borne by the owners. Among numerous other options, the LLC can be seeded with income producing assets to fund the premiums. Another option is that the principal entity can pay the premiums indirectly through presumably equal distributions, dividends or compensation to the members or shareholders of the principal entity, who then contribute the funds to the LLC for payment of the premiums.
- Ease of Administration: The use of an LLC in buy-sell planning provides a centralized vehicle to administer the policies, rather than leaving the responsibility and oversight up to the individual owners. The use of an LLC to own life insurance in conjunction with a properly structured buy-sell agreement can provide the ideal structure for a smoother transition and more security for small businesses upon the death of individual business owners. Consequences of Operating Without a Buy-Sell Agreement
Without a contract in place, several potential scenarios can occur if a member retires, dies, or otherwise leaves the LLC. For example:
- If a member dies, his or her shares would automatically pass to heirs, who could sell them off or attempt to run the company in a way the other owners disagree with.
- If a member divorces, the court could award his or her shares in the business to the ex-spouse, who could also sell or interfere in the business.
- If a co-owner wants to sell his or her shares, a dispute over proper value could result if an agreement is not in place. The company could be dissolved if there is no resolution.
- In the event of a disagreement, an owner could sell shares to a competitor or another unapproved individual or entity.
Before funding the agreement, the owners need to know how much insurance coverage to purchase on each partner. After deciding which type of agreement structure, they want, the owners must then agree on how to value the business. There are several ways to value the business: Owners can decide on a fixed amount per share and, as the business grows, may annually or periodically reevaluate that and increase death benefits accordingly. This will allow for a value that grows, along with the business, over time.
Owners may agree on a particular formula using a moving value such as book value, fair market value, or three times the average value of net profits for the last three years or simply use a stated value method where members agree on a purchase price and document it in the buy-sell agreement.
Death benefits should be periodically reevaluated so that proper buy-sell funding is ensured.
Funding the Agreement
A buy-sell agreement can be funded in many different ways. Some companies, when they have sufficient liquidity, may decide to self-fund the agreement. Most choose the easy, flexible, affordable structure of permanent life insurance policies to generate the cash that will be necessary for the execution of the agreement whether its due to death, disability or resignation.
Using a Premium Finance Bank to Fund Your Buy-Sell Agreement Premiums
Insurance premiums for policies that are used to fund buy-sell agreements can be substantial, and can be difficult for many business owners to manage. For cross purchase agreements, the personal requirement to pay premiums can take a substantial amount out of each owner’s income. With redemption agreements, the company must have enough cash on hand to pay for all of the policies—regardless of how expensive the premiums might be due to the health or age of some of the owners.
Using Premium Financing to fund life insurance and annuity strategies creates an alternative means to pay necessary premiums without tying up company cash or personal income.
By utilizing Premium Financing as a solution, individual owners and corporations can easily fund buy-sell agreements using life insurance policies with death benefits that will fulfill the obligations brought on by the valuation methods chosen.
How It Works
The premium necessary to fund the life insurance is borrowed from a low interest rate, specialized premium financing banks that allow you to fund either a cross purchase, redemption, or LLC buy-sell without any additional collateral outside of the policy used to fund the agreement.
When a business is first starting out, the decisions about what to do with cash can make or break the company’s future. Later on, strategic investments can increase the company’s growth and future prospects. This leaves little flexibility for business owners to pay for premiums that fund their buy-sell agreement. Even a cross purchase plan, with its heavy focus on individual policies purchased by each owner, the financial burden can be tremendous. Borrowing the large premiums to fund the Buy Sell agreements allows your business to retain scarce, needed capital. Premium Financing solutions offer a great way for business owners to protect their business and personal capital while still fulfilling their most valued succession and legacy plans.