Business partners and shareholders of closely held businesses need to be concerned with the potential that one of the partners will die prematurely or is permanently disabled. If the estate of the deceased stipulates the business is passed on to that shareholder’s family, who may not be desired as partners, have no interest in the business, or are likely to interfere in the business without any experience in managing it, major difficulties can be created for the business and the surviving partners. In extreme cases, thriving businesses have failed or forced into a sale when this happens. Buy-sell agreements can solve this problem, by providing the business with the cash necessary to buy out the surviving family’s interests in the business.
There are typically two types of buy-sell agreements, which I discuss in this article. The first is a cross-purchase agreement, where each partner or shareholder buys a life insurance policy on the other partners or shareholders. For a small partnership, corporation, with only two shareholders or partners, a cross-purchase agreement can work well, since only two policies are necessary. However, in situations where there are more than two partners, a cross-purchase buy-sell agreement can become difficult to manage: for example, if there are three partners or shareholders, six policies are needed (three people each buying two policies for each partner); if there are five partners, twenty policies are needed (five partners each buying four policies on each of the other partners). As you can see, these numbers increase rapidly. To further complicate issues, buy-sell disability insurance (DI) policies that buy out a disabled partner’s share of the business, so the numbers double if DI policies are added to the mix. In addition, both life and DI policies are rated by age and health, so there can be wide disparities in the premiums each partner pays. Tax implications can also play a role: if the partners have a higher tax rate than the corporation, the cost of funding will be higher than the alternative to cross-purchase agreements.
The alternative variant of a cross-purchase agreement is a stock redemption agreement, where the corporation owns the insurance policies on each partner. If a partner dies or is disabled and can no longer contribute to the business, the insurance policy allows the corporation to buy out the partner’s business interest. Because the corporation owns the insurance policies, it is only necessary to have it buy a policy for each partner, making the administration much simpler than a cross purchase agreement. Further, underwriting differences that affect premium are borne by the business rather than creating disparities with each partner’s cost of insurance. The biggest problem with a stock redemption agreement is that the remaining shareholders do not get an increase in basis valuation, but retain the original basis cost of the shares. As a result, the partners will be liable for greater capital gains with the stock redemption structuring if shares are sold before death. However, if the stock redemption is accomplished, each owner now has a greater percentage of ownership. There can also be a hybridized approach, where combinations of cross-purchase and stock redemption are used to structure the agreement.
There are numerous other tax implications that are beyond the scope of this article. Suffice it to say, the tax consequences of these insurance agreements must factor in tax implications vis-à-vis the amount of complexity the partners are willing to assume. It is necessary to have the partners work with their insurance agent, accountant, and attorney as a team to find the best solution, given the tradeoffs that have to be made.
What happens if a partner is uninsurable? If that partner already owns life insurance and DI policies, the ownership of the policies can be transferred to either the partners (cross-purchase) or business (stock redemption). If the life insurance policy is a cash value product, the partner will have to be compensated for the cash surrender value of the policy. Again, tax implications are important here, as well: the partners must engage their accountant and attorney to structure this arrangement appropriately.
The type of insurance used for the buy-sell agreement can be term or cash value. As with individual policies, both have advantages and disadvantages. Annual Renewable Term (ART) policies have the advantage of low up-front costs, but increase as the partners’ age. Level term policies will have a predictable cost structure, but expire at the end of some predetermined period, say ten or twenty years, depending on what’s purchased. Once the end of the term is reached, the policy holders must each go through underwriting once again to get new policies, but because they are older, these will be substantially more expensive, and there s a good risk that one or more partners may not be able to get any insurance due to age and/or health. In the latter case, the risk can be mitigated with the purchase of a guaranteed insurability rider, but this adds to the cost of the policy.
Cash value policies, typically Whole Life (WL) and Universal Life (UL) have the advantage of building cash value and remain in force as long as premiums are paid., The policies can self-fund after a period of time as generated dividends become sufficient to cover the premiums. Alternatively, the policies can continue to be funded and the cash value used to fund or supplement pension benefits or shareholder buyouts. Additionally, because the cash value is treated as a liquid asset, the funds can be used to secure advantageous loan terms for the company.
The partners can decide to forgo any buy-sell agreement if they determine the cost of the insurance exceeds the likelihood of higher capital appreciation of their interest in the business. Therefore, the partners may decide the risk of premature death or disability of a partner is sufficiently low that reinvesting the money into the business to realize a higher rate of return than the insurance policies can offer is a better bet for the owners.