Understanding the Buy-Sell Agreement
A buy-sell agreement is designed for partners or multiple owners to protect the business if one of the owners were to die unexpectedly.
Basically, this agreement addresses the fundamental continuity of the business for the remaining owner(s) through buying out the deceased owner’s share of the business from their heirs.
Each owner purchasing a life insurance policy on the other owners of the company arranges this. There are many different versions, but one highly popular version is called the “cross-purchase buy-sell agreement”.
In the cross-purchase agreement, owners buy an individual policy on each of their partners. The total amount of life insurance is equal to their respective share of the net worth of the business.
Usually a cross-purchase agreement works best if your company has four owners or less — that’s not to say you couldn’t do a cross-purchase agreement with more, but it gets more complicated when there are more owners involved.
Why would you want a buy-sell agreement?
The biggest reason is that it ensures the business can survive the unexpected death of a partner.
Without a buy-sell agreement, you may have to sell or liquidate the business to pay heirs what they are due, or you could find yourself in a partnership with the heirs.
I know this might sound harsh at first, but think about this for a moment. If you have a partnership with someone, then chances are you chose that partnership because you work well together, right?
If they were to suddenly pass away and there was no buy-sell agreement, then you could easily be in a situation where you don’t have the cash to buy-pay for the other half of your company. Or you could as easily look up one day and find yourself in a partnership with their spouse or one of their children.
You have no work history with this person, and they probably don’t know the business very well.
In both situations, it can get messy quickly!
A simple buy-sell life insurance policy can ensure you don’t fall victim to one of these circumstances.
A Basic Example of Buy-Sell Life Insurance at Work
To give you a basic example of how this works, let’s say a corporation with four owners is worth a total of $4 million dollars.
Each partner owns an equal 25% of the business. That makes each partner’s buyout share $1 million.
In this case, each partner would buy one policy on the other three partners (4 x 3 = 12) leaving the death benefit to be worth $333,333.
Each partner would be considered an owner, would pay the premiums, and would be the beneficiary of each policy they purchased on the lives of the other business partners.
Now let’s say one of the owners dies suddenly.
The remaining 3 owners would each receive a death benefit of $333,333 for a total of $999,999 and then they could collectively use these funds to buy out the heir(s) of the deceased partner from their business.
In the end, the heirs of the deceased get a $1 million buyout and the 3 remaining partners now own 33.33% of the company and continue in business together.
Technically, someone is going to need to throw in an extra buck to round it out to an even $1 million, but you get the idea, right?
Make It Official
One thing that is very important in all this is the actual buyout agreement between the partners.
This needs to be an official agreement between partners and can’t be something you scribbled down on a napkin one day at lunch.
Hire a good attorney to draw up the agreement and get all details worked out and in writing! Once you have the agreement in place, it will provide a clear outline of how the deceased owner’s heirs will sell their interest to the remaining owner(s) with the insurance proceeds.
And it will all be legally bound!
One of the big benefits of this type of buy-sell agreement is the family of the deceased owner’s tax basis will be equal to the fair market value at time of death, making for favorable tax treatment on the death proceeds.
I know these types of agreements can be pretty confusing, so if you’d like to talk in more detail about your situation, give us a call today. We can walk you through the benefits and answer questions you have.