Key Takeaways
- A buy-sell agreement may provide a roadmap for transferring ownership if a business owner dies, becomes disabled, or departs.
- Life insurance may offer one of the most effective ways to fund these agreements by creating immediate liquidity, reducing disputes, and protecting both heirs and surviving partners.
- Reviewing existing agreements and insurance funding is important in light of the Supreme Court decision in Connelly v. United States.
- Capital Formation Group can assist business owners in reviewing and designing buy-sell agreements that align with their goals for continuity, fairness, and long-term financial stability.
Running a business requires planning for both growth and risk. While owners often focus on expansion, sales, and operations, fewer dedicate time to asking: What happens if one of us dies, becomes disabled, or leaves unexpectedly?
Without a plan, the business could face turmoil: disputes between heirs and partners, financial strain from having to buy out an ownership share, and even the risk of closure. A buy-sell agreement may be one of the most powerful tools to address these risks. It sets the rules in advance and may help ensure that all parties are aware of what could happen when a triggering event occurs.
However, having the agreement on paper may not be enough. It also needs funding. Otherwise, surviving partners may struggle to pay heirs fairly or maintain the company’s stability. Life insurance may be one of the most efficient ways to provide that funding. The right coverage can create liquidity for partners, while heirs may receive fair value for the deceased owner’s interest.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract that outlines what may happen to an owner’s share of a business if they leave due to death, disability, retirement, or another triggering event.
The Core Purpose
- Business stability: May reduce disruption by establishing a clear succession process.
- Fair valuation: Could solidify that heirs of a deceased owner receive compensation at a pre-determined or appraised value.
- Continuity for partners: Provides a framework for surviving partners to maintain control and potentially keep the business operating.
Without such an agreement, a deceased partner’s spouse or heirs might inherit ownership, even if they have no interest in running the business. This could create tension, stalled decision-making, and the possibility of forced sales. A funded buy-sell agreement may reduce this uncertainty.
Why Fund a Buy-Sell Agreement With Life Insurance?
Drafting an agreement is only half the process. Funding it is where the real protection may lie. Life insurance is often considered effective because it can offer:
- Immediate Liquidity: Death benefits may be available quickly, providing survivors funds to fulfill the agreement.
- Predictable Funding: Unlike loans or installment sales, insurance may provide a reliable payout without burdening the business at a vulnerable time.
- Fairness and Certainty: Surviving owners and heirs know in advance that funding may be available.
Other Options and Their Drawbacks
- Cash Reserves: Businesses may struggle to keep large amounts of cash on hand, and inflation can erode their value.
- Loans: Borrowing during a crisis can be expensive or even unavailable. Lenders may hesitate if the business’s stability is in question.
- Installment Sales: Payments spread over time may strain finances and prolong ties between family members and the company.
Life insurance may overcome these hurdles by creating a lump sum right when it is needed most.
Types of Buy-Sell Agreements
Cross-Purchase Agreements
- Each owner buys a policy on the lives of the other owners.
- If one dies, the surviving owners may use the death benefit to buy the deceased owner’s share.
- Works best with two or three owners but may become complex with many partners.
Entity-Purchase (Stock Redemption) Agreements
- The business owns life insurance policies on each owner.
- When an owner dies, the company may use proceeds to redeem shares.
- Simpler to administer with multiple owners, as the business holds the policies.
For example, in a three-owner firm, a cross-purchase agreement might allow the two survivors to each purchase half the deceased’s share. In a ten-owner company, an entity purchase may be more practical to avoid a web of overlapping policies.
How Life Insurance Works in a Buy-Sell Arrangement
Policy Ownership and Beneficiaries
- In cross-purchase setups, individual owners own and are beneficiaries of policies on their partners.
- In entity-purchase agreements, the company is both owner and beneficiary.
Triggering Events
- Death of an owner.
- Disability (if included in the agreement).
- Retirement or voluntary departure.
Example in Practice
Imagine a business worth $6 million with three equal owners. Each holds a one-third share valued at $2 million. Under a cross-purchase arrangement, each partner owns policies on the others for $2 million each. If one partner dies, the surviving two may receive $2 million from the insurance and pay the deceased owner’s estate. The business continues with two equal partners, while the family may receive fair value for their share.
Tax Implications of Using Life Insurance to Fund a Buy-Sell Agreement
Income Tax Treatment
In many cases, life insurance death benefits are received income-tax-free by the beneficiary. However, exceptions exist. We do not provide tax advice. Consult your tax professional for guidance.
Estate Tax Considerations
If the policy is personally owned, proceeds may be included in the deceased owner’s estate, potentially increasing estate tax exposure. Structures such as an ILIT (Irrevocable Life Insurance Trust) may help mitigate this. We do not provide tax advice. Consult your tax professional.
Corporate-Owned Policies
- Certain reporting rules may apply for corporate-owned life insurance (COLI).
- Section 101(j) requires compliance with notice and consent rules for employer-owned life insurance policies.
- Failure to meet 101(j) requirements may cause death benefits to be taxable.
We do not provide legal or tax advice. Please consult your professional advisors.
Common Pitfalls
- Transfer-for-Value Rule: If policies are transferred improperly, death benefits may become taxable.
- Alternative Minimum Tax (AMT): Rarely, corporate-owned policies could raise AMT considerations.
Because the rules are complex and subject to change, agreements may benefit from review with tax and legal advisors. We do not provide legal or tax advice. Please consult your professional advisors.
Advantages and Challenges of Life Insurance Funding
Advantages
- Stability: May provide financial security for heirs and partners.
- Certainty: Creates known funding rather than relying on uncertain borrowing.
- Immediate Liquidity: Benefits may be available shortly after death.
- Creditor Protection: In some states, death benefits may be shielded from creditors.
Challenges
- Premium Costs: Premiums may be expensive for older owners or those in poor health.
- Valuation Changes: If the business grows, coverage may fall short.
- Insurability Issues: Some owners may not qualify due to medical history.
Managing Challenges
- Schedule periodic valuations to help ensure coverage aligns with business value.
- Add supplemental coverage or adjust policies as the business evolves.
- Consider alternative funding for uninsurable partners, such as installment arrangements or sinking funds.
Best Practices for Structuring a Buy-Sell Agreement
- Align Valuation Methods: The valuation method in the agreement may align with what is used in insurance planning.
- Clarify Ownership: Make sure that the policy ownership and beneficiary designations reflect the agreement’s structure.
- Review Regularly: Agreements and policies may be updated as the business grows or ownership changes.
- Engage Advisors: Legal, tax, and financial professionals can help identify risks. We do not provide legal or tax advice. Please consult your professional advisors.
FAQs: Buy-Sell Agreements Funded By Life Insurance
How much life insurance is needed?
Coverage may reflect the value of each owner’s share, updated as the business grows.
Can disability insurance also fund a buy-sell?
Yes. Disability buy-out policies may provide funding if an owner becomes permanently disabled.
What if business value exceeds coverage?
Supplemental funding or additional policies may be needed.
How often should agreements be reviewed?
Every few years, or whenever ownership or valuation changes significantly.
What does coverage cost?
Premiums vary based on age, health, policy type, and death benefit size.
Are life insurance proceeds always tax-free?
Not always. Exceptions exist depending on ownership, transfer, and corporate structure. We do not provide tax advice. Please consult your tax professional.
Securing Your Business Future With the Right Plan
The absence of a buy-sell agreement, or having one without funding, may leave businesses vulnerable to disputes, financial stress, or even closure. By funding an agreement with life insurance, owners may provide a more orderly path forward for families, partners, and employees. Planning ahead could support transitions that are fair and consistent with long-term business goals.
We May Be Able to Help with Buy-Sell Agreement Planning
At Capital Formation Group, we can work with business owners to design and fund buy-sell agreements that support continuity, fairness, and long-term goals.
This May Include:
- Reviewing existing agreements and policies.
- Identifying funding gaps or overlaps.
- Aligning strategies with succession and estate planning.
- Coordinating with your tax and legal professionals. (We do not provide tax or legal advice. Please consult your professional advisors.)
Contact Us or Schedule a Meeting
You can schedule an appointment online or call/text us at (781) 237-0123. A customized review may help you feel more confident that your business, your partners, and your family are prepared for life’s uncertainties.
Required Disclosures:
The material is for informational purposes only and is not intended to provide specific advice or recommendations for any individual, nor does it take into account the particular investment objectives, financial situation, or needs of individual investors. This information is not intended for use as legal or tax advice. Persons should consult with their own legal or tax advisors for specific legal or tax advice. Guarantees are based on the claims-paying ability of the carrier offering the guarantee. All examples are hypothetical and are for illustrative purposes only.
This blog was created with the assistance of ChatGPT. The content has been reviewed and curated to ensure accuracy and relevance.
Securities offered through Valmark Securities, Inc., Member FINRA, SIPC. Investment advisory services offered through Valmark Advisers, Inc., an SEC-registered investment advisor. 130 Springside Dr., Suite 300 Akron, Ohio 44333-2431 • 1-800-765-5201.
Capital Formation Insurance Agency, Inc. and Capital Formation Group, Inc. are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc. Diversification cannot assure a profit or guarantee against a loss.
