What is Buy-Sell Insurance?

Operating agreements between business owners are legal, binding contracts between owners of a business, addressing the concerns of the owners and “what-if’s” of the business proactively.

One of the chief concerns among business owners is: what happens if one of us dies? How will this affect the business, the other owners and the heirs of the deceased owner? The surviving owners want to ensure managerial and operational stability by not having a share of ownership fall into the hands of potentially inexperienced heirs, and want to protect themselves and the business financially. The heirs want to ensure that they are compensated fairly for the shares that they have inherited.

A buy-sell provision within the operating agreement addresses all of these concerns.

What Is A Buy-Sell Agreement?

Upon the death of one of the owners, the remaining owners or the business itself are required to purchase the deceased’s interest in the business according to the agreed upon terms in the provision. The deceased’s heirs are required to sell their inherited interest at the agreed upon price.

Sounds great, right? The heirs are paid fairly for their shares, and the remaining owners retain all of the shares of the business.

The follow-up question is: where does the money come from to buy those shares? How is the buy-sell funded? As a basic example, if a business has 2 owners, and the business is valued at $6 million, each owner’s interest is $3 million. But in all likelihood, that value is tied up in fixed or intangible assets.  If one of the owners dies, where does the $3 million come from in order to buy back the shares inherited by the deceased owner’s heirs?

Funding the Buy-Sell Agreement

There are a lot of different ways to fund a buy-sell agreement, but some carry more risks than others.

Some owners choose to save money from the business now and pay the heirs in cash. The downside of this is that the owners will be tying up business capital that could be used elsewhere to grow the business.

Some plan to take out a loan to buy out a deceased owner’s share from their heirs. This may be problematic because a bank may hesitate to, or decline to, provide a loan to a business that just lost an owner. In addition, the loan repayments may hurt the business’s cash flow, which may be struggling after losing an owner.  Moreover, the remaining owner will likely be required to personally guarantee the loan.

One of the most popular methods for funding a buy-sell agreement is through life insurance. Whether term insurance or whole life insurance is used, there are multiple benefits to using life insurance to fund a buy-sell, such as:

• Funds are immediately available when a death occurs
• Death benefit proceeds are generally income-tax free
• The funds used to buy the insurance – the insurance premiums – can be very inexpensive, and are likely to be significantly lower than the cost of repaying loan interest.

There are two ways to structure buy-sell insurance:

• Cross Purchase Buy-Sell: In this scenario, the owners enter into agreements with each other. Each owner purchases a life insurance policy on the other owners, and is named the beneficiary of the policy. If an owner passes away, each surviving owner receives the life insurance proceeds income-tax free and uses the proceeds to purchase the business interests back from the heirs. The heirs sell the shares to the remaining owners at the agreed-upon price.

In a business with more than one owner, this becomes inefficient, as each owner would need to purchase life insurance on each of the other, resulting in multiple policies. This can be resolved by setting up a trust to own the insurance policies instead of the owners themselves.

In addition, if the ages of the owners are substantially different, younger owners will be required to pay more expensive premiums for the older owners’ life insurance policies. Again, this could be resolved through a trust, where the policies would be consolidated. The trustee would own the life insurance policies, collect the death benefit if an owner dies, and purchase the deceased owners’ shares back from the heirs for the agreed-upon price.

• Entity Plans: In this scenario, also known as a stock redemption plan, the business purchases life insurance policies on each owner, with the business itself as the beneficiary. If an owner passes away, the business receives the life insurance proceeds income-tax free and uses the proceeds to purchase the business interests back from the heirs. The heirs sell the shares back to the business at the agreed-upon price, and the shares are distributed per the buy-sell provisions.

When a business owns life insurance, it is critical to comply with the notice and consent requirements of IRS 101(j) in order to preserve the income tax free nature of the death benefits. Please be sure to coordinate with a benefits attorney to assure that these requirements are followed.

What’s The Value Of The Business?

Once the owners of a business decide to fund their buy-sell with life insurance, the next question is: how much insurance should they place on the owners? This is determined by the value of the business, and the amount of ownership.

The buy-sell agreement will specify how the value of the business is determined, and is typically determined in one of three ways:

• Agreed-Upon Value: The easiest way to specify the value of the business is by agreeing on a dollar amount, and specifying that amount in the buy-sell provision. However, this doesn’t account for an increase (or decrease) in value as time passes, and is generally not advisable.
• Fair Market Value At Time Of Sale: This is the most accurate way to determine a business’s value, but is also usually the most expensive, because it involves a professional appraiser. If the business is valuable enough, the accuracy of the valuation may be worth the additional cost of the appraiser.
• Formula-Driven Valuation: If the value of the business isn’t large enough to justify the professional appraiser’s cost, but is large enough that a fixed value doesn’t make sense, using a formula may be the answer. This is usually done by taking a multiple of Earnings Before Tax, Depreciation and Amortization (EBITDA), and depending on the business type, the book value of the company may factor into the equation as well. Different industries tend to use different formulas to value a business, so knowing what formulas are commonly used is important.

Using a formula is a great approximation for a business’s value, but may not account for certain other factors, such as intellectual property, resulting in an undervaluation of the applicable shares.

Non-Economic Impact

Another important consideration is the non-economic impact of not funding a buy sell agreement. What if the remaining owners or the business is not able to buy their shares back from the heirs? This could result in unintended control and authority of a business that they potentially (likely) know nothing about, which could be potentially disastrous for the business. A carefully worded operating agreement, with a properly funded buy-sell agreement, can prevent the transfer of ownership interest to heirs that are not qualified.

In Conclusion

Business owners spend years building a successful, profitable business, and buy-sell provisions in an operating agreement assure that the remaining owners are protected, there is business continuity, and the heirs are paid fairly if the unexpected were to occur. Life insurance is an efficient, effective way to fund the buy-sell agreement, resulting in income tax free proceeds to the heirs and financial protection and operational stability for the remaining owners.

Monarch Financial Advisors

Does your operating agreement have a buy-sell provision? Is it funded? Let’s partner with your tax professionals and business advisors to make sure both answers are “yes”!

Contact us with any questions – our team is ready to help protect you, your business, your family, and your future.