When a business's founder dies, the firm loses about 60% of its sales, and jobs are cut by about 17%. Then for two years following the founder’s death the company has a 20% lower chance of survival than its competitors. The key to business survival is exit planning.

Exit planning means the procedures the company will take to survive following your retirement or death. As a business owner, you may be wondering about the financial security of the business and your family if you were to die. A buy-sell agreement funded by life insurance may be the perfect exit plan for you.

You've never heard of buy-sell agreement insurance? Keep reading to learn the benefits and types of this business owner option.

What Is a Buy-Sell Agreement?

A buy-sell agreement is a legal contract between the owners of a business. The contract is similar to a buyout agreement. A buy and sell agreement details what will happen if a co-owner exits the business. This may be due to a voluntary leave, death, or being forced out by other owners.

The agreement gives all owners and their families peace of mind. Everyone knows what happens to the business and each owner's interest in the business if one partner leaves for any reason.

What Is a Buy-Sell Agreement With Life Insurance?

Life insurance provides funding for the buy-sell agreement. The company or its owners purchase life insurance policies for each co-owner. If you are a co-owner of a business and die, the company or other owners receive the death benefits from your policy.

The buy-sell agreement with life insurance includes specific steps following your death. The co-owners receive your life insurance death benefits. Your family receives a cash payment for your interest in the business.

This provides financial security and stability to the company and your family.

Types of Buy-Sell Agreements

When preparing a buy-sell agreement, the structure of the agreement will vary to fit your particular business needs. Your Life insurance advisor will work with you and all business partners.

They will review the different types of insurance available for the business. They may also provide information to meet additional needs on a personal level.

Cross-Purchase Plan

When you create a cross-purchase plan each owner buys life insurance for the other owner(s). Each owner is responsible for paying the premiums of the policy they own and is the beneficiary of the policies they purchase.

When an owner dies, the surviving owner collects the death benefit. They then use those benefits to purchase the deceased owner’s business interest from the family.

For example, if Amy and Alice have joint ownership in a bakery with a value of $500,000, they each purchase a $250,000 life insurance policy on the other. When Alice suddenly dies in a car accident, Amy collects $250,000 in benefits from the life insurance policy she purchased.

Amy then pays Alice’s family $250,000 for her 50% interest in the company. Amy now owns the bakery free and clear in her own name only and continues operating the business on her own.

When establishing this type of contract you want to make sure it specifies that the business co-owner(s) have the first option to purchase a deceased owner’s interest in the business.

If the business has more than 2-3 owners, it becomes more complicated because each person must hold policies on all other owners. In the event of death, each individual owner must purchase just their own insured portion of business interests from the deceased's family.

The benefit of this agreement plan is a quick and easy payout upon the death of a business owner. The downfall is with multiple business owners, there are multiple policies each owner must purchase and fund. If the business increases the number of owners or partners, it may be beneficial to change over to an entity redemption plan.

Entity Redemption Plan

This plan involves each individual owner having their own separate agreement with the business regarding their respective business interests. The business then purchases individual insurance policies against the lives of its owners. The business pays the premiums for those policies.

Under this type of agreement, if an owner dies their share of the company stock passes to the owner’s heirs or estate. The company may then purchase the shares from the family using proceeds from the life insurance policy.

Going back to the bakery, let's say it has three owners, Amy, Alice, and Alexandria. The business has a value of $750,000, with each person owning 1/3 of the business.

The bakery business purchases a $250,000 life insurance policy on each of the three owners. When Alice dies in a car accident, the business collects $250,000 in benefits from the life insurance policy. The bakery pays Alice’s family $250,000 for her share of the business.

Amy and Alexandria are now the only two owners of the business, each with a 50% interest. Because their individual interest in the company now has a higher financial level, this would be a good time for them to schedule an insurance review.

The benefit of this type of agreement is that the business owns the life insurance policies. This means the policy benefits are not subject to reaching the owner's creditors or being included in their estate. If an owner leaves the business, the policies of other owners are not affected as they would be in a cross-purchase buy-sell agreement.

Hybrid Plan

The hybrid plan is a combination of entity redemption and cross-purchase plans. Upon the death of an owner, the business has the first option to purchase the business interest of the deceased equal to the insurance proceeds. If the business declines or there are remaining shares available after their purchase, the other owners or business partners have the option to buy.

Using the bakery situation with Alice and Amy as owners, the business has a $500,000 value. The business purchases $500,000 life insurance policies on Alice and Amy.

When Alice dies in a car accident, the insurance company pays out $500,000 in benefits, $250,000 to the bakery, and $250,000 to Alice’s family. Amy then uses the $250,000 benefit she receives to purchase Alice’s shares of interest from her family. This allows Amy to remain the sole owner of the bakery, and Alice’s family benefits by receiving $500,000 in cash.

Things to Keep In Mind

The insurance and buy-sell agreement contract work in tandem to bring peace of mind to everyone. Things to keep in mind when establishing the contract include:

• The buy-sell agreement needs to be fully funded—each life insurance policy needs to equal the owner's percentage of interest in the business
• If there is a discrepancy between the insurance proceeds and your interest percentage in the business, how is the difference handled?
• If the insurance proceeds exceed your interest portion of the business, does the excess go to the business or your estate?
• If premiums are not paid the insurance will lapse; include a provision for ongoing proof of payment
• How long does each life insurance policy need to be viable?
• Are the policies to be term life insurance or permanent life insurance?
• If an owner is unable to qualify for insurance, what additional funding methods are acceptable?
• Insurance premiums paid by a company for funding a buy-sell agreement are not deductible as a business expense
• Call rights—the business may elect to purchase an owner’s interest for a premium percentage of the fair market value
• Put rights—an owner can demand the business purchase their interest in the business at a percentage of the fair market value
• Right of first refusal—an owner may sell their interest to an outside party only if the existing owners waive their rights to purchase
• Deadlock provisions provide a means of dissolving the business or one partner's interest in the business

Because of changing values as a business grows or declines, it is important to undergo a review of your coverage on a regular basis. The insurance coverage on each owner may need to increase if a business is expanding. If the business is declining in value, it may be advisable to lower the death benefit of the policies.

Cost vs Benefits

One of the key benefits of a buy-sell agreement funded by life insurance is that proceeds are usually paid out quickly. With sufficient cash values on the policies, the funds make it easy for your interest in the business to be purchased whether your withdrawal is due to death, retirement, or disability. Life insurance proceeds are normally free from income tax obligations.

You may wonder about the cost of buy-sell agreement insurance. That will vary depending on the individual policy benefit amount, age of the person being insured, and the health of the insured To learn more about the costs of this policy, contact Hummel Group for more information.

Advice From Your CPA

The importance of small and medium-sized businesses having a buy-sell agreement in place is increasing. More than 30 million privately held businesses in the U.S. have baby-boomer owners transitioning into retirement. Having an agreement in place prior to a business owner leaving helps the process flow easily.

Whenever you are considering a business contract that affects the financial aspect of your business, consult with your accountant. Your CPA will ensure you receive all tax benefits. They will also confirm that the financial contract implications clearly define your intent.

Your buy-sell agreement will include a valuation clause regarding the terms of a buyout and a definition of the business value. This may be referred to as “fair value” or “fair market value.”

These two terms appear to be the same. In the accounting world, they have different implications when determining the value of a business interest.

Fair Market Value

Fair market value is defined in the Revenue Ruling 59-60. The value is the price that will be paid if the property changes hands between a seller and a buyer when neither has any compulsion to sell or buy. The value of the property is based on two willing parties with reasonable knowledge of all relevant facts regarding the property.

Fair Value

There is no common definition for fair value. It is open to a wider interpretation by attorneys, accountants, and the court system.

The American Institute of Certified Public Accountants uses the term for fair value measurements under the Accounting Codification Standard 820. The same fair value term is applied to owner disputes by attorneys and the court system.

A business appraiser may consider the fair market value to imply certain valuation discounts regarding a noncontrolling or minority interest in the business. Those discounts will impact the marketability of a business interest, lowering its value.

To avoid any such pitfalls and future disputes, it is advisable to consult with business appraisers, accountants, and attorneys when drafting a buy-sell agreement. Each professional will advise regarding specific terminology interpretations within the contract.

Review and Preparation of Contract

To avoid problems with the wording and legal standing of the sell-buy agreement, it is advisable to have it reviewed or prepared by an attorney. The payment of legal fees when establishing the agreement may prevent conflict. The contract needs to meet legal contract criteria and have appropriate wording to meet the intent of all owners.

Attorneys are familiar with the legal requirements of a contract, including buy-sell agreements. To be enforceable a contract must stipulate the terms and conditions each party agrees to in exchange for money or other compensation. The elements of a contract include:

• Offer and acceptance—the agreement between the parties
• Capacity and undue influence—those entering into a contract must have the mental and physical ability to do so
• Intention, form, and legality—parties must intend for the contract to have legal consequences
• Terms and conditions—the backbone of the contract administration
• Breach of contract—what happens if a party does not fulfill their contractual obligations

It is advisable that prior to signing the contract be reviewed by an accountant and a business valuation professional to make sure the terminology will be interpreted correctly.

Get a Buy-Sell Agreement Insurance Quote Today

By purchasing buy-sell agreement insurance you are providing a business exit plan that provides financial security to your business and family in the event of an unforeseen death. At Hummel Group we offer both personal and commercial types of insurance in a wide range of niche markets to meet your needs.

We encourage you to get an insurance review and quote now for the different types of insurance you may need. You may also call us at 800-860-1060 with any questions.

When you own a business you need to develop procedures that take effect in the event one of the co-owners dies or becomes disabled and unable to work. While key employee insurance provides coverage for the loss, it is different from the exit-plan provisions of a buy-sell agreement with life insurance.

Buy-sell agreement insurance provides financial backing for your buy-sell agreement. It is normal to look at the bottom line regarding the cost vs the benefits. Learn here about the different types of buy-sell agreements, different types of insurance, and their impact on your buy and sell agreement cost.

Buy-Sell Agreement Determines Life Insurance Owner

There are two main types of buy-sell agreements. The type of buy-sell agreement your business has or will develop determines who purchases the life insurance. It also affects the coverage amounts of each policy.

Cross-Purchase Plan

If your company enacts a cross-purchase plan, each owner or partner needs to purchase a life insurance policy on every other owner. When one owner dies, the remaining owners collect as a beneficiary on the life insurance they bought. Those funds are paid to the deceased person's family to buy out their interest in the business.

If you have a company with only one or two other owners, this may be an ideal arrangement for you. The way the agreement works is:

• Amanda, Amy, and Amelia are joint owners of a hair salon that has a value of $200,000
• The owners each own one-third of the business, a business value interest of $66,667
• The buy-sell agreement states that each member will purchase $35,000 life insurance policies on the other two owners
• When Amanda dies in an auto accident, Amy collects $35,000 on the policy she owns and Amelia collects $35,000 on the policy she owns
• Amelia and Amy each pay Amanda’s family $33,333.50, a total of $66,667 for Amanda’s interest in the business
• Amelia and Amy now own the business as partners, each with a 50% interest

The buy-sell agreement designates how the extra $8,333 each collected on the life insurance policies will be used. The use of the overage is agreed upon by all owners when establishing the contract terms.

The agreement may require payment of any excess benefits go to Amanda's family to reduce their financial burden. It may require excess go back into the business to cover loss the business incurs due to Amanda’s absence. It may allow each owner to keep the overage for their own personal gain.

If the company is larger, with several co-owners or partners, this type of policy may be financially cumbersome because of the number of life insurance policies each owner must purchase. That is when an entity or stock redemption plan may be a better choice.

Entity or Stock Redemption Plan

This type of buy-sell agreement includes a clause where each owner or partner agrees to sell their interest in the business upon death. The business is responsible for purchasing life insurance policies for each owner. The business owns and is the beneficiary of those policies.

The business pays the insurance premiums. This eliminates the personal out-of-pocket cost for each owner. When an owner dies, their share of the company passes to their heirs or estate.

The business collects the life insurance benefits on the policy they own. The company then uses that cash to purchase the deceased owner's business interest from the estate.

This benefits the company as they secure ownership of the company. The family receives cash for their interest in the business, providing financial security for their loss.

Using the same example as above, the hair salon Amanda, Amy, and Amelia own purchases one life insurance policy for $70,000 on each owner. When Amanda dies in a car collision, the business collects the $70,000 benefit. The hair salon then pays $66,667 to Amanda’s family or estate as payment for her interest in the business.

The buy-sell agreement will designate how the extra $3,333 in benefits will be distributed or used. While there is less overage in benefit payouts for the company to use, each owner has not made out-of-pocket payments to cover the life insurance of the other co-owners. After the buy-out, Amy and Amelia each own 50% of the business.

Buy and Sell Agreement Insurance Types

Term and whole life are the two types of insurance available for purchase. Most businesses purchase term insurance for their buy-sell agreements.

Term insurance is cheaper, but only covers a set number of years. It is possible to use whole life policies for buy-sell agreements. When using this insurance, the buy-sell agreement usually includes provisions for rolling the insurance over to the insured in the event they leave the company prior to death, such as for retirement.

Term Insurance

This type of insurance covers the insured for a set period of time, such as 10-20 years. If you die within the coverage period it will pay out the policy amount to the designated beneficiary.

If you die after the designated period, no benefits are paid. The premiums you paid remain with the insurance company. This insurance is considerably cheaper but offers no dividend benefits because there is no accumulation of cash value.

Whole Life Insurance

When you purchase whole life or permanent life insurance, you receive coverage that lasts your entire life. The insurance comes with an investment account that accrues cash value over time. The premiums are higher but remain the same for as long as you live.

The death benefit is guaranteed and pays out when you die. Your beneficiaries receive both the face value of the policy and the accumulated cash value.

The cash value is an investment account that a portion of your premiums goes into each month. The account continues to grow over time. Once the cash value reaches a certain level, you can borrow against the account.

Additional Cost Factors

Just like personal life insurance, there are numerous factors that impact the cost of each policy bought to fund a buy-sell agreement. This includes the age, health, and habits of the insured. Other factors include whether you purchase term or whole life policies and the death benefit amount.

The average cost is difficult to determine when considering life insurance. Companies usually do not report premium data. This may be to protect information about their policyholders' privacy, which includes information about the insured’s age and health.

When obtaining a quote, it is important to be honest about your life habits. This includes habits such as drinking, smoking, and other high-risk activities.

If you lie to get a lower premium and the insurance company finds out, they may cancel your policy. They may also refuse to pay your death benefit. This is allowable if the coverage is obtained by providing false information.

With a buy-sell agreement, facts relative to the business will also have a bearing on the cost of the insurance.

What Is Your Business Worth?

The value of your business will impact the amount of coverage you purchase for each business owner. A large business with annual revenue of $5 million and five partners will require each partner to have a $1 million life insurance policy. The business pays the premiums and is the beneficiary with an entity or stock redemption agreement.

If the company has a cross-purchase buy-sell agreement each of the five partners will need to purchase four (4) $250,000 policies, one for each of the other four partners. The four policies collectively cover the $1,000,000 interest of each partner.

When putting together your buy-sell agreement, talk to Hummel Group about which method of purchasing policies is most cost-effective. You must also consider the out-of-pocket costs for each partner vs the business owning the policies.

Age and Gender

Women have a longer life expectancy, which lowers the cost of their premiums. The average life expectancy is 79 years for women, 72 years for men. Because of their lower lifespan, men are usually more expensive to insure than women of the same health and age.

At the same time, the older you are when purchasing a policy, the higher the premiums will be. That is because of the increased risk the company may have to pay out the death benefit before they collect a comparable amount of premiums.

If your business has a mixture of ownership in men and women or older and younger people, the cost to insure each individual owner for the same death benefit may vary considerably.

Death Benefit Amount

The cost of your policy premiums will vary depending on the amount of the death benefit. If you have a small company where each owner only needs $50,000 in insurance to cover their interest in the company the premiums will be very reasonable in cost. If the business is larger and each person requires a death benefit of $500,000, the premiums will be higher.

Work You Perform

Even as an owner, the task you undertake at work may have an impact on the cost of your life insurance. If you manage a construction company and are out on the sites or assisting in builds you have a high-risk position. Other high-risk occupations include logging, farming, roofing, and more.

Health of Owners

The health of each business owner has a huge impact on the cost of their buy-sell agreement life insurance. Each owner will likely need to complete a health questionnaire and receive a physical before receiving approval.

Anyone who uses any type of tobacco product will have a higher life insurance premium. Being a regular consumer of alcohol may also likely impact your insurance costs. This is because of the health risks these activities create.

If a person is a risk and unable to receive a standard policy, they may want to inquire about a guaranteed issue policy. This is a policy that does not require you to answer questions about your health or have a medical exam.

Lifestyle

People who participate in extreme sports during their free time will likely have a higher cost for life insurance. These are sporting activities with characteristics that include high speeds and high risk. You may be surprised at some of the activities that make this list and can impact your insurance premium costs:

• Skateboarding
• Snowboarding
• Freestyle Skiing
• In-Line Roller Skating
• BMX
• Mountain Biking
• Racing and acrobatic motorcycle and snowmobile competitions
• Zorbing—riding inside of a giant inflatable ball
• Scuba Diving
• White water rafting
• Blobbing—a giant airbag in the middle of a lake you jump onto, causing liftoff
• Parasailing
• Alpine skiing and snowboarding
• Wakeboarding and water skiing

This is just a short example of extreme sports that may impact life insurance premiums. There are many activities that we think of as "normal" but they come with a high risk of injury or loss of life.

Get a Review

It is important to contact your insurance provider for a review of your business insurance coverage. Changes in your business value or the death of an owner may increase or decrease the amount of coverage you need.

Whenever your business experiences a significant change in revenue, ownership, or any other area contact Hummel Group to make sure the financial needs of your business are being met.

Is Buy-Sell Agreement Life Insurance Tax Deductible?

The premiums the business or owners purchase to fund a buy-sell agreement are not tax-deductible. The plus is that the death benefits are usually not subject to federal income tax.

There are some instances, such as C corporations, where there are some taxes assessed. The price established in a buy-sell agreement for an owner’s business interest may set the value for federal taxes if proper legal requirements are met. This includes the price being based on a professional appraisal.

The appraisal uses a formula that includes:

• The outlook in the specific industry and general economy
• Goodwill
• Prior sales of business interests
• The financial condition of the business
• Company’s assets book value
• Company’s earning history
• Company’s future earning potential

The best way to make sure you meet all your legal tax obligations is to consult with your tax accountant.

Buy-Sell Agreement Insurance: The Bottom Line

Use buy-sell agreement insurance to fund the exit plan for your business in the event an owner dies. This provides peace of mind in what will happen to the business.

It provides the finances necessary for remaining owners to buy out the deceased owner’s business interest. It also gives clear direction on who the remaining owners will be and establishes how the business is valued.

Whether you have not yet set up a buy-sell agreement, have the agreement and need it funded, or need a review on whether your business has sufficient insurance coverage, Hummel Group can help. We will review the coverage you have and make recommendations, including how to improve your risk management. Contact us today at 800-860-1060.