Oct 30
Life insurance used in a buy-sell agreement can preserve your business
Buy sell agreements are mainly for small businesss owners. They can be used to transfer ownership when one or more of the business owners retires or dies. They ensure that the ownership structure of the business is preserved, that the business will continue, and heirs will receive a fair amount for the previous owner’s business interest when life-changing event occur.
Consider Tom and Jerry, the owners of a sales company. Tom has the sales expertise and Jerry runs the operations side. Their profitability is due to their joint efforts. If Tom were to die prematurely, Jerry would have to hire a new employee to fill Tom’s position. With the new hire, it’s unlikely that they could duplicate Tom’s results. At the same time, Tom’s widow would want to continue to take the same money out of the business that Tom had received. Needless to say, it may be impossible for Jerry to continue a profitable business under such circumstances. However, such a situation can be avoided. A properly drawn and funded buy-sell agreement can prevent such a disastrous result.
The buy-sell agreement allowsthe surviving owner of the business to purchase the deceased share of the operation. When a buy-sell agreement is structured you should determine the purchase price to be paid or provide a formula for determining the price. More importantly, the agreement must have a way for providing the funds needed to make the purchase. This is where life insurance comes into play. For example, if Tom’s interest in the business is valued at $100,000, Jerry would have to raise the funds to purchase Tom’s portion of the business. A “first to die” policy should be set up to pay the death benefit on death of the first business owner, thereby ensuring that funds are available for the buy-out regardless of which partner dies first.
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November 14th, 2006 at 8:40 pm
Buy-sell agreements must have a funding mechanism to be effective, and life insurance is one of the most effective such mechanisms in the event of the death of a shareholder. However, the shareholders need to discuss and document their buy-sell agreements to clarify whether life insurance proceeds are specifically a funding mechanism — for the sole purpose of purchasing the shares of a deceased shareholder, or whether the proceeds create a corporate asset, which becomes part of the value of the company to be purchased. This is not a distinction without a difference!