By: Dennis Zink
July 9, 2019
Many businesses want to ensure their continuation when an owner becomes disabled or dies. This is accomplished when the surviving business owners or the business itself purchases the deceased or disabled owner’s business interest. The agreement to sell and then buy the business interest when a triggering event occurs; is accomplished with a contract known as a buy sell agreement for businesses.
A buy sell agreement for business creates an obligation on behalf of the deceased or disabled owner, or their estate, to sell their interest. At the same time, it commits the designated buyer to purchase that interest. Such commitments tend to ensure that the amount to be paid for the business interest is fair to all concerned. Thus, the estate of a deceased business owner or a disabled business owner is assured of a fair price for that interest.
The price may be stated in the agreement, or it may contain a formula to be used to determine the buy-sell price at the time the triggering event occurs. If the price for the business interest is a stated amount in the agreement, the price should be updated annually to reflect a reasonable value for the business interest.
Because this amount may be consequential for the buyer(s), life insurance usually provides the best way to accomplish the buy-sell.
Life insurance and disability insurance are purchased by the buyers of the business interest on the owner whose death or disability will trigger the buyout. When death or disability strikes, the insurance then delivers the necessary funds to fulfill the buyers’ commitment under the buy sell agreement for business.
Although any type of life insurance may be used – term, whole life, or universal life — a permanent life insurance policy is generally favored due to the uncertainty of the date of the insured’s death. Universal life is often preferred because of its permanent nature, as well as its premium and death benefit flexibility. Premium payments may be suspended during slow cash flow periods, and the death benefit may be increased or decreased to reflect changes in the value of the business.
Disability buyout policy benefits are payable upon an insured’s total disability, if disability endures for as long as the policy’s elimination period. The elimination period is a time-based deductible: It’s the waiting period before benefits begin, starting the day you become ill or injured. Disability buyout policies do not ordinarily provide benefits for partial or residual disability. The elimination period in disability buyout policies is usually 12 to 24 months. Although disability benefits payable upon the insured’s disability may be paid in installments, the most common disability buyout benefit payment is a lump sum.
The amount of disability buyout benefit, the duration of the elimination period, and the benefit payment option are determined in the buy-sell agreement that the policy is intended to fund. Depending upon whether the agreement is an entity (stock redemption) plan or a cross-purchase plan, the policy may be owned by the business or by the other partners or stockholders.
The disability buyout insured must be totally disabled for the entire elimination period in order to trigger the benefit. However, once the elimination period has ended, there is no requirement for the insured’s continued disability. Even if the insured were to recover after the elimination period, the disability benefit will be paid, and the buyout will proceed.
When a business owner completes a buy-sell agreement for business by adding a provision for business succession in the event of disability and funding the buyout provision with a disability buyout policy, two goals are accomplished:
Business succession is planned for in the event of the business owner’s disability, and funds are provided to meet the disability buy-sell obligation created by the agreement.
Determination of the business owner’s disability lies in the hands of the insurance company rather than in those of the business or the other owners. It is critical that a third party makes the disability determination rather than the other parties to the buy-sell.
When an owner of a business interest in a close corporation dies without having a buy sell agreement for business for the remaining owners (or for the business itself) to purchase the decedent’s shares, the decedent’s heirs generally inherit the shares and become part-owners of the business. Assuming that the new owners have no prior experience in the business, or have objectives that are at odds with those of the other owners, the results could be disastrous.
Upon the death or disability of a business owner, the three options generally available to a business are:
Selling the business as a going concern upon the death or disability of a business owner is usually more desirable for everyone than liquidating the business interest or retaining it in the decedent’s family where no competent, willing heirs are available to assume business ownership responsibilities.
Transferring the business interest to other current owners of the business, other partners or stockholders, is the most sensible arrangement. Businesses and business owners facilitate the buy sell agreement for business transaction by ensuring that appropriate amounts of life insurance and disability insurance are purchased and maintained by the potential buyers. This type of agreement is referred to as an insurance-funded buy-sell agreement.
If the proceeds of a disability policy or the death benefits of a life insurance policy are paid to a co-owner of the business so that the benefits are used to fund a cross-purchase buy-sell agreement, then the policy benefits will be received income tax-free. If the business owns the plans (an entity plan), insurance benefits are also received tax free as long as; the insured has been notified in writing of the coverage, is advised who the policy’s beneficiary is, the insured gave written consent to being the insured and for the policy to remain in force in the event of their termination.
Note that premiums paid are not tax deductible. If I can help, please contact me at [email protected]
Note to readers: Much of this information was culled from taking continuing education credits (CE) for renewal of my insurance license for life, health and annuity (Florida 215).