Life is unpredictable, and sometimes the unthinkable happens and we lose a loved one or a business partner.
For many small businesses, the passing of a partner could lead to a number of issues regarding ownership, with the future of the organization in doubt if the surviving family members of the deceased want to sell their stake. That could bring in a new partner that may not share the same visions or operating culture as the remaining owners.
To avoid this turmoil, you should consider a buy-sell life insurance policy agreement that sets the stage for an orderly sale of the deceased’s stake back to the company or partners from their heirs. There are two options: a cross-purchase plan, or an entity purchase or stock redemption plan.
Cross-purchase plan
Each business owner purchases a life insurance policy on each of the other owners. When an owner dies, the surviving owners use the death benefit to purchase the deceased’s share of the business.
The cross-purchase buy-sell agreement is the most popular buy-sell life insurance structure for a small corporation with no more than four owners. More than that and it can get quite convoluted.
A cross-purchase agreement requires each owner to buy an individual policy on each of their partners. So that means if you’re a partner in a four-partner outfit, you would buy a policy on each of your three partners and each of them would do the same.
At the end of the day, there would be 12 life insurance policies (4 partners x 3 policies = 12 policies). Obviously, if you have more than four partners, the number of policies needed increases exponentially.
Each partner will be the beneficiary and owner of the policies they buy on their partners.
These policies also are accompanied by an agreement that outlines how the deceased owner’s heirs will sell their interest to the remaining owner(s) for the insurance proceeds.
One of the benefits of this type of buy-sell agreement is that the tax basis of the family of the deceased owner will be equal to the fair market value at time of death, making for favorable tax treatment on the death proceeds.
Entity purchase or stock redemption plan
As a part of this type of agreement, the business – not the partners – purchases separate life insurance contracts on the lives of each owner.
The business pays the premiums and is the beneficiary should one of the partners die. Under this type of buy-sell arrangement, the ownership of the business would pass to the partner’s heirs or estate and the business would use the payout from the life insurance policy to buy out the deceased’s stake.
The good thing is that the deceased partner’s family receives a payout based on fair market value of their share of the business.
For the surviving partners, an entity purchase or stock redemption plan is easier to manage than a cross-purchase plan, particularly when there are multiple partners. Also, the partners themselves don’t need to purchase individual policies for each of the partners.
Precautions
One key aspect to buy-sell agreements is that the amount of insurance coverage on each partner’s life should equal the value of their ownership interest. The life insurance should be fully funded to pay the deceased’s heirs a fair payout for their share.
The agreement should also specify how each partner’s heirs or estate is compensated. You should also revisit the policies each year to ensure that the payout for each partner comports with the current value of the business.
Finally, there are tax implications that you need to consider for both types of agreement. We recommend talking to a tax advisor. We can also help you decide.