Life insurance offers tools and strategies that will help guarantee that your small business survives into the next generation.
Buy-Sell Agreement:
A buy-sell agreement is a legally binding contract that stipulates how a business partner’s share of the business may be reassigned when a specific event occurs such as death, retirement, divorce, or disability. In general there are to types of buy-sell, a cross-purchase agreement and entity purchase agreement.
With cross-purchase agreements the owners buy life insurance on each other. The agreement is that the surviving partner will buy out the other’s interest, funded through life insurance proceeds. The downside to cross-purchase is when there are more than two owners. As an example, if the business has four owners, twelve life insurance policies must be purchased as each owner buys a policy on the other.
Entity purchase agreements alleviate the complexities of multiple owners and life insurance policies because the owner of the life insurance policy is the business. When a partner dies the business uses the life insurance proceeds to pay the deceased owner’s estate for their share. The downside to entity purchase agreements is that they don’t allow for the tax preferred step-up basis, cross-purchase agreements do.
A better solution in most cases is a buy-sell LLC. The LLC owns the life insurance policy. Surviving owners receive a step-up in basis as well as cash that provides flexibility in succession planning. The owners create a cross-purchase buy-sell agreement, the LLC owning a life insurance policy on each owner. The owners pay into the LLC capital account, and the LLC pays the premiums on each life insurance policy. The life insurance policy is protected from business creditors.
The buy-sell LLC has more to offer. When an owner dies the LLC, as a life insurance beneficiary, pays the deceased owner’s estate their share. The estate transfers ownership shares to the surviving owners. The surviving owners, as members on the buy-sell LLC, may tap into the cash value of their own policy through loans or withdrawals. These funds may be used to buy out other owners or retire. If the business closes or an owner retires the LLC can be terminated. Transfers of policy ownership to other members is tax-free.
As always, talk to your legal and tax advisors before implementing any buy-sell agreement.