The business buy-sell agreement is an ideal instrument that, upon your death, will create a fund of money to be used to pay your family or estate the full value of your share of the business. And life insurance is what makes the business buy-sell agreement work.
How funding with life insurance works?
Just as with any life insurance policy, at the death of the insured, the beneficiaries receive a death benefit. But in the case of the buy-sell agreement, the life insurance policies are either owned by the company, insuring each part owner, or owned by the partners with the other partners as the insured. The money from the policy is then paid to your surviving family members in return for your share of the business.
Advantages of using life insurance to fund buy-sell agreement
- Life insurance creates a lump sum of cash to fund the buy-sell agreement at death
- Life insurance proceeds are usually paid quickly after your death, ensuring that the buy-sell transaction can be settled quickly
- In general, life insurance proceeds are received free of income tax
- If, at some point, you choose to retire from the business, or become disabled, the cash values that have built up can be used to purchase your business interest
Disadvantages of using life insurance to fund buy-sell agreement
- As with all life insurance policies, age and illness may make one or more of the co-owners uninsurable
- Since life insurance premiums are based largely on age, the premiums for policies on different co-owners could vary widely. This is a disadvantage to the younger owners under the “cross purchase” buy-sell agreement (see below).
- If the ownership percentages vary widely, more insurance will be needed to cover the owners with the larger ownership interests, resulting in higher premium costs for those with smaller ownership interests
The Two Types of Business Buy-Sell Agreements
There are two methods from which to choose in setting up a business buy-sell agreement: the “Entity” purchase and the “Cross” purchase. For entity purchase buy-sell agreements, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and is the owner and beneficiary of the policies.
For cross purchase buy-sell agreements, each co-owner buys a life insurance policy on each of the other co-owners. Each co-owner usually pays the annual premiums on the policies they own and are the beneficiaries of the policies. If your company has a large number of co-owners, multiple policies must be purchased by each co-owner.
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