Life Insurance In A Buy Sell Agreement

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Congratulations on looking into one of the most important questions a business owner can ask: What to do if a business partner or co-owner dies, becomes disabled, or retires?

Planning ahead with a Buy-Sell Agreement provides an excellent answer to this question, and it’s a very smart move on your part.

Every business owner or partner should look at their own exit strategy from the business. But they should also be thinking about their partners’ potential exits as well — whether the exit is planned and expected or sudden and unexpected.

Before we discuss the use of life insurance in funding a Buy-Sell Agreement — or “business will” as it is sometimes called — let’s dig a little deeper into the details of these agreements.

What Is A Buy-Sell Agreement?

buy sell agreementA Buy-Sell Agreement is one of the most important but least used legal agreements for business partners or co-owners.

Its purpose: to plan ahead in case one or more owners or partners leave the business through death, disability, retirement, or forced exit.

I’ve found that not many business owners have a Buy-Sell Agreement because it falls into the “not urgent” category.

Don’t make this mistake for your business. This kind of agreement may seem “not urgent” right now, but it can become “very important” very quickly. By then, it may be too late.

Don’t be like the 64 percent of businesses that don’t have a Business Continuation plan (LIMRA).

How Is A Buy-Sell Agreement Structured?

Generally, an agreement is structured in one of two ways:

Cross-Purchase

Businesses with only two or three partners can successfully deploy this strategy. Each partner would buy some amount of the ownership percentage of the other partners. Each owner typically also purchases a life insurance policy on each of the other partners.

The purchaser is the owner and beneficiary of the life insurance policy on the other partners. If one of the other partners died, the surviving owner could file a claim for the policy’s death benefit, which could be used to buy out the deceased partner’s share.

Entity Concept

This strategy works well when a business has several owners or partners. The business itself would buy the ownership interest of each partner.

The business also buys a life insurance policy on each owner/partner. The business is the owner and beneficiary of each policy, and each owner is an insured person.

If one of the partners died, the business could file a life insurance claim and use the money to buy out the deceased partner’s share.

When your business sets up its Buy-Sell Agreement, make sure you hire your attorney to structure the agreement. The attorney’s fees will be money well spent, and a third party helps business partners discuss and make decisions while everyone is alive and on the same page.

Under normal circumstances, no one knows when a death may occur. It’s way easier to have this discussion now rather than waiting until illness or death changes the playing field, making negotiations more one-sided.

Why Every Business Should Have A Buy-Sell Agreement

Every business should have a Buy-Sell Agreement for at least these three reasons:

  • Comfort and Peace of Mind: An agreement provides some comfort and peace of mind because all partners, as well as their beneficiaries, know major decisions about the distribution of the business assets that have to been handled.
  • IRS Business Tax Valuations: A Buy-Sell agreement provides a way to measure the value of your business. This valuation makes IRS documentation easier when required.
  • Funding Mechanism: Since a life insurance payout would fund the buyout of a deceased owner’s share, surviving partners or the business itself wouldn’t have to come up with the funds, making the transition much more affordable.

Without a Buy-Sell Agreement, the deceased owner’s share could transition to his or her spouse or children.

Most of my clients would not want to be in business with their partners’ spouses. Neither would they prefer discussing business valuations and business practices and procedures with their former partner’s surviving spouse or estate beneficiaries.

Do Sole Proprietors Need a Buy-Sell Agreement?

Many people think you’d need at least two or more owners or partners to even think about a Buy-Sell Agreement.

However, many sole proprietors and individual business owners have asked me if they needed a Buy-Sell Agreement and whether to use life insurance to help fund the agreement.

My answer is YES. A very unusual agreement called a One Way Buy-Sell Agreement could exist even between friendly competitors in the same industry.

This kind of agreement can help avoid a “fire sale” by a surviving spouse or heirs. The spouse, or beneficiary, would know the deceased had already provided a way for business assets (such as phone number, customer lists, inventory, etc.) to be sold for a reasonable price.

Reasons To Fund A Buy-Sell Agreement with Life Insurance

Life insurance should fund your Buy-Sell Agreement for these obvious, and a few not-so-obvious reasons:

  • Pennies on the Dollar: Death benefit proceeds from a life insurance policy always exceed the premiums paid to the insurance company. Paying premiums lets you leverage a much larger amount of cash if needed.
  • Fixed and Budgeted Amount: Paying fixed monthly premiums to the insurance company helps you “budget” for the payout, regardless of how many years later the death occurs.
  • Flexibility: If you use a permanent life insurance policy, you could also use the cash surrender value buildup to make an initial payment to purchase a retiring partner’s stock in the event of retirement – even if a death doesn’t occur.
  • Insurability: Many people — even sharp business owners — delay buying life insurance until they are much older. This will cause a problem if the owner develops a health issue that could prevent him or her from qualifying for life insurance later. Applying for a policy now ensures that the policy would remain in force even if the insured developed a health condition later.
  • Additional Benefit: After an owner’s retirement, the ownership of the life insurance policy could be used in the final buyout negotiations, especially if the retiring partner had developed a health condition that prevented him or her from purchasing additional life insurance, making the existing policy even more valuable to the owner.
  • Additional Coverages: Newer permanent life insurance policies include long term care benefits which can provide a retiring owner even more incentive to “buy” or negotiate for the business-owned life insurance policy.

Most of the time, life insurance proceeds may not provide enough money to buy all the deceased owner’s stock. But the life insurance payout could fund a down payment, which could be combined with some type of installment payouts from the business.

What Life Insurance Company Is Best For A Buy-Sell Policy?

I suggest using a company with at least an A- rating by A.M. Best Rating Services, Inc. These are called Best’s Credit Ratings (BCR).

No one – not even A.M. Best — can guarantee the future financial strength of any business, but you don’t want to pay a premium to an insurance company for years and years and have the company go bankrupt.

So get quotes from financially stable life insurance companies as much as possible.

Major Decisions To Make Before Applying For Life Insurance In a Buy-Sell Agreement

Before you apply for the life insurance that will fund your Buy-Sell Agreement, think about these important decisions:

Death Benefit

To determine the death benefit amount for the policy, you must first do your best to determine the current valuation of the business.

Your business’s valuation will probably change from year to year, but the insurance policy’s death benefit cannot be changed from year to year. So be sure you’re thinking about how your business is trending into the future.

Even if the death benefit exceeds the amount needed to buy out an owner’s stock, the leftover money can serve any other business purpose, such as funding a signing bonus to help hire a key person to replace the deceased partner.

Additionally, the death benefit may be different for each current partner or owner. The benefit can mirror each individual partner’s percentage of ownership in the business.

One of the hardest steps will be assessing the value of the business, but an accurate valuation will make setting the proper death benefits possible.

But even if the death benefit can’t cover 100 percent of the value – and even if you can’t determine the value of the business — having some life insurance funds are better than none.

Ownership

Who will own the life insurance policies which fund your Buy-Sell Agreement? The partners or the business itself?

As discussed above, the answer to this question should depend on the number of owners and partners. With three or more partners, the business itself should probably own the policies.

Here’s another consideration of ownership: If premium payments vary widely on two partners as a result of age, health differences, or tobacco use, how will that premium disparity be handled between the partners?

And here’s yet another question to consider: Would the policy ownership change in the event of a retirement or disability of one of the owners?

These are complex questions. As I suggested above, an attorney can help sort this out.

What Type of Life Insurance Should Fund Your Buy-Sell Agreement?

So what type of life insurance should you get? Should a permanent or a term life insurance policy fund your Buy-Sell Agreement? You’ll have some flexibility with this decision, because all of the policies in the agreement do not have to be the same.

For example, if one owner is much older and closer to retirement, it might make financial sense to buy a less expensive term life policy on that owner.

A much younger owner who is in good health may be better served by a whole life policy. The premiums would be cheaper due to the owner’s younger age, and the policy would have time to accrue a surrender value to be used many years down the road.

While many decisions must be made, don’t let analysis paralysis prevent you from executing a necessary and prudent business decision. That is another topic altogether – execution in business decisions.

How Do You Apply For A Buy-Sell Life Insurance Policy?

So you’ve…

  • Determined the death benefit amount
  • Decided on the type of insurance (permanent or term)
  • Agreed on who will own and pay for the coverage
  • Named the insured and beneficiary for each policy

Once you have all these decisions made, go ahead and apply for the life insurance coverage and get the underwriting started.

Business Buy-Sell Life Insurance policy death benefits are usually larger amounts and can take some time to get issued.

You can get excellent rates here from several life insurance companies who understand business life insurance.

Here are some important things to know about the Application Process:

Underwriting Can Vary

Every insurance company has its own set of policy issuance rules, called Underwriting Guidelines, that determine whether the company will issue a policy or not.

Underwriters will consider:

  • your height and weight
  • health-related issues
  • tobacco use
  • personal annual income
  • family health history
  • amount of the death benefit
  • among other considerations.

If you can’t qualify for the policy you’re asking for, underwriters may decide to make you a different offer for coverage.

Expect a Medical Exam & Conversation

You may be required to have a paramedic examiner come to your home or place of work to administer a medical exam, including, measuring your height and weight, asking you some health questions, and even give you an EKG test.

They may also swab your mouth or obtain blood samples to send off to a lab.

One warning I will tell you now: If a representative of the company says you will be getting a 20-minute phone call to ask you some health questions, don’t believe it.  Be prepared for 45 minutes.

You can speed up the conversation if you have your doctor’s name, phone number and address, ALL prescriptions, ALL over-the-counter medications, and any other health information you have available.

Other Considerations When Setting Up Your Buy-Sell Agreement

As you can see, creating a Buy-Sell Agreement and funding it with life insurance will take some time and planning. But all the work will be worthwhile if something unexpected happens and you can avoid chaos and maintain business as usual.

When you have the basics of your plan in effect, it’s time for a little fine-tuning:

Disability Income Considerations

Don’t forget about considering a Business Buy-Sell disability income policy, or even a personal disability income policy for a sole proprietor.

The poor or failing health of an owner or partner causes many of today’s business failures.

Keep the Agreement Current

Make it a point to revisit your business’s agreement every year or so with all partner owners. Business valuations and percentages of ownership can change, and even if the death benefits do not change, it is important to keep the agreement as accurate as possible.

Life Insurance Contestability Policy

Typically, the insurance company has a two-year window after coverage begins to investigate the life insurance application and potentially deny a claim.

Insurers look mainly to see if there was any intentional misrepresentation or fraud on the application.

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