With Key Person Coverage and Buy-Sell Agreements:
You put maximum effort into establishing and running your business. But are you taking the right steps to make sure your business can survive the retirement, disability, or death of an owner or key employee?
When these events occur, your business may be significantly impaired or forced to close in a relatively short period of time, not because you did something wrong, but because you did nothing.
Business succession planning is crucial to ensure the successful transfer of your company or business interests. And yet few owners even know what their business is worth or have planned for the eventual transfer of their business interests. This section of our website will discuss stabilizing and maximizing the value of a business and transferring it to the parties desired under specified, controlled circumstances. It is designed to help you retain control of your business and to assure that funds will be available to provide maximum financial flexibility in the event of retirement, death, or disability, or if you leave the business.
Key Person Coverage
Who do you consider a key person in your business? The person you rely on when you are not in the office? The one who works best with your customers? The person who finds creative ways to finance your business? You may already have a number of incentives to keep such employees working for you, including future ownership. But can the business afford to lose them now?
How long would it take to replace your key person(s) and how much business does your company stand to lose? An insurance policy on the key person's life, owned by the business, may be the answer. At the death of the insured, the business can use the federal income tax–free life insurance proceeds to find and train a successor and to replace the revenue lost by the untimely death of a key person.* Your insurance professional can work with you to estimate the appropriate amount of life insurance needed within your business budget.
Many business owners think a buy-sell agreement is not needed until the death of a business owner. While it is critical to have a plan in place at that time, the buy-sell is also important when any major life event changes the relationship of one of the owners to the business. Such an event could be disability, divorce, retirement, conflict between owners, or the desire of one owner to pursue another business opportunity. In each case, having a buy-sell agreement in place can help to mitigate conflict and speed up the transition by giving business owners a road map for handling the event.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract that can be used with all types of businesses. It stipulates that upon a triggering event, such as the death, retirement, disability, or other withdrawal of a principal, his or her share of the business must be sold to the remaining partners or shareholders, or to the business itself. The remaining partners, shareholders, or the business itself agree to purchase the portion of the business owned by the deceased, retired, disabled, or withdrawing principal.
The agreement also helps to prepare for the manner of the owner's withdrawal from the company. For example, if an owner withdraws from his or her share of the business for medical reasons, the potential buyer may have purchased disability income coverage to help provide the funds necessary to buy out the withdrawing principal at that time. Life insurance would be purchased to fund the agreement at death or retirement of an owner.
The buy-sell agreement, regardless of form, should specify certain key provisions. It must be drafted by an attorney. It is critical that the buy-sell agreement set out the intent of the parties in a manner that is legal in your state. The following information must be known for insurance planning and must be clearly explained in the buy-sell agreement:
- Parties—Who will be selling and who will be buying?
- Mandatory—The buy-sell agreement must state that it is mandatory for the seller to sell and for the buyer to buy the business interest.
- What is to be purchased?—This differs with each business type. For instance, it could be partnership interests, membership interests, stock—or for a sole proprietorship, the business' assets.
- Price—How much does the owner or the owner's estate get for his or her business interest and how much does the buyer have to pay for this business interest?
- Timing of the sale—For all parties involved, timing of the sale is critical.
- Law—Which state law(s) will apply?
- Changes to the agreement—A buy-sell agreement usually exists for a number of years. The process to update coverage should be established.
- Termination of the agreement—There are valid reasons to terminate a buy-sell agreement, thus having an exit provision can be useful.
Types of Buy-Sell Agreements
Cross Purchase: With this arrangement, each business owner purchases life and/or disability insurance on the other business owners. Each owner is the beneficiary of his or her respective policy(ies). The business is not part of the agreement. Upon the disability, death, or withdrawal of one owner, the remaining business owner(s) can use the policy proceeds or cash values to purchase their pro rata shares of the withdrawing owner's interest in the business.
In the case of sole owners, this agreement can be structured as a one-way agreement, where a buyer such as a key employee or third party purchases a life insurance policy on the sole business owner. At the owner's death or retirement, the buyer uses the policy proceeds or cash value to purchase the owner's entire business.
Stock Redemption: The stock redemption buy-sell agreement is generally used with any business entity that has multiple owners who want to use the assets of the business to fund the agreement. The business is the purchaser, owner, premium-payor, and beneficiary of life insurance policies on each owner's life. When an owner dies, the business receives the death benefit and uses the proceeds to purchase the business interest from the deceased owner's estate. The estate is paid the agreed-upon price, and the surviving business owners own the entire business.
The business will show the life insurance policy cash values as a business asset. However, premiums paid by the business are nondeductible. Stock redemption may not be as advantageous for C corporations because policy cash accumulations and death benefit may be subject to alternative minimum tax and, in the case of closely held businesses, family attribution rules may result in unforeseen tax consequences.
Wait-and-See: The primary advantage of the “wait-and-see” buy-sell agreement is its flexibility. Often, the decision between cross-purchase and stock redemption is difficult because of the inability to predict the future and determine which plan will be better for all parties. The wait-and-see agreement can adjust to future tax law changes, fluctuating economic times, or owner uncertainty. The wait-and-see is a hybrid agreement containing language of both previously mentioned buy-sell agreements which allows either the surviving principal(s) or the business itself to purchase the withdrawing owner's interest. The decision is not made until an owner actually withdraws from the business.
Combination Buy-Sell: The combination buy-sell is a nontraditional arrangement in which a general partnership is used to structure and fund a business buy-sell. This special arrangement combines the benefits of both a cross-purchase and stock redemption/entity purchase while avoiding their negative aspects. With this arrangement—in addition to establishing a traditional buy-sell agreement for the business—the owners of the business establish a separate general partnership, which owns and names itself beneficiary of life insurance policies insuring the lives of the owners. The owners make contributions to the partnership to fund the payment of the premiums. At the death of one of the owners, and according to the terms of the buy-sell, the death benefits can be:
- distributed to the surviving owner(s)/partner(s) to fund a cross-purchase-type buyout;
- lent by the surviving owners to the business to fund a stock redemption or entity purchase; or
- used by the partnership to buy the deceased owner's interest.
Advantages of Buy-Sell Agreements to the Owner and His or Her Heirs:
- Facilitates a market for what might otherwise be an unmarketable asset.
- Helps avoid family disagreements regarding the value of a business, as well as the legal and emotional costs of a valuation dispute.
- The heirs' economic futures will no longer be tied to the fate of the business and they will be free from worry about the financial success of the business.
- Specified proceeds can provide the decedent's estate with funds to help meet estate obligations that can reduce or eliminate the need to liquidate other estate assets.
- Helps establish the value of the business for federal estate tax purposes and may, therefore, avoid costly and aggravating IRS litigation.
- May avoid the conflict of interest issues that arise when a key employee takes over
Advantages of Buy-Sell Agreements to the Business and/or Surviving Principal(s)
- Ensures a smooth and complete transition of management and consolidation of business control in the hands of the agreed-upon group.
- Protects the business against inactive, unqualified, and/or potentially dissident heirs
in the management of the business.
- The business and/or the surviving principal(s) are assured of the cash necessary to purchase the decedent's interest.
- Prevents potential impairment of the business' credit line.
- A properly drawn buy-sell agreement can protect a corporation's subchapter S status by avoiding inadvertent conversion to C corporation status.
Notice of Reporting Requirements for Employer-Owned Policies
Life insurance policies owned by an employer or corporation (commonly referred to as “EOLI” or “COLI”) where the employer or a related person is the beneficiary are subject to legislation, known as the “COLI Best Practices” rules, enacted in August 2006. The Best Practices rules require that notice be given to, and the consent of the individual to be insured be obtained before the policy is issued. If the notice and consent requirements are not followed, then the death benefit would be included in the beneficiary's gross income.
These rules generally limit COLI to officers, directors, and highly compensated employees. There are exceptions to the employee rule. If the notice and consent requirements are met and the insured fits into one of the following three exceptions at the time that the policy is issued, then the death benefit will be income tax–free to the beneficiary:
- The employee is a highly compensated individual or director (i.e., among the highest paid 35% of all employees as defined in IRC Section 105(h)(5)), or
- The employee is a highly compensated employee as defined by IRC Section 414(q), or
- The insured was a director within the 12 months preceding his/her death.
The employer must comply with annual recordkeeping and tax return reporting requirements pursuant to these rules. Since buy-sell agreements such as stock redemptions, wait-and-see, or combination buy-sell agreements may involve a life insurance policy owned by the employer, such policies can be governed by the rules.
Although most buy-sell agreements would appear to fall within one of the exceptions to the rules, due to changing circumstances, the purpose of holding a policy may vary over time. For instance, a policy intended to be used for a stock redemption may ultimately be used as key person insurance. Nevertheless, the employer must continue to follow the notice and reporting requirements of the rules to remain within one of the exceptions.
In order to proceed with a buy-sell agreement, it is important to determine the value of the business entity both now and periodically in the future. An accurate valuation allows for all parties to be treated fairly and can minimize conflict at the time of the business transfer.
It is advisable to seek a professional evaluation in order to make sure the buy-sell agreement can withstand scrutiny by all parties involved at the time of the triggering event.
Planning Ahead to Minimize Risk
All business owners want to minimize risk in order to protect themselves and their businesses from economic loss and to increase the likelihood of success. For the protection of yourself, your family, and your business, it makes sense to reduce the risk of loss at the death of a key person or at the time of business transfer. Business succession planning is key to the successful transfer of your company or business interests.
Your insurance professional can help you plan today to retain control of your business and to assure that funds will be available to help provide financial flexibility in the event of retirement, death, disability, or other severance of relationship with the business.
Funding a Buy-Sell Agreement
There are three primary methods to funding a buy-sell agreement.
Requires large sums of liquid assets that may not be readily available, particularly at the time of an unforeseen event.
May have to liquidate valuable personal or business assets below market value in order to raise cash quickly.
The loss of an owner or key person may impair the credit rating of the business and its ability to borrow.
Principal plus interest must be paid. This could be a tremendous strain on the business budget.
- Purchase a Life Insurance Policy
Money is available from the policy cash values or death benefit for the purchase of the business interest.
Policy cash values grow tax deferred and death benefits are federal income tax–free.*
* For a C corporation, the life insurance death benefit and annual increases in cash value may be subject to the corporate alternative minimum tax.