There are two significant reasons for a client to have an updated and funded buy-sell agreement. One is to allow the surviving partner to maintain sole control of the business if one of the owners or partners were to die prematurely or become disabled.
The other is to provide an immediately available sum of tax-free dollars to pay the deceased partner’s family for their share of the business or practice. A written agreement would establish an updated value of the business, how much money the deceased’s partners’ family would receive, over what period of time and most importantly, where the funds needed to pay the deceased partner’s family would come from.
Having discussed the value, terms, mechanics and funding beforehand would not only provide for an orderly transition of the business but also avoid unnecessary disputes settled by costly litigation.
Doing so would also prevent key people, employees, vendors and customers from leaving the business, thereby maintaining the full value of the business or practice for the surviving partner and their family. Lastly, a properly drafted, funded and annually updated valuation of the business could peg the value of a business for estate tax purposes.
There are basically three types of buy-sell agreements: cross-purchase, stock redemption, and wait and see. For the purposes of this article, we’ll focus on the two most popular: the cross-purchase and stock redemption. The wait and see has components of both types of agreements but doesn’t require a decision until death occurs. The cross-purchase agreement is an agreement made directly between the partners of a business or practice. Each partner is the owner, beneficiary and premium payor of the other partner’s life Insurance policy. As always, there are benefits and detriments to any planning options and the cross-purchase is no exception.
In a cross-purchase agreement, the distinct tax benefits to the surviving partner are that at their subsequent death, their family would receive a step up in basis to the current value of the business. For example, if a business is initially valued at $1million and then over 20 years later it’s worth $3 million, there would be no capital gains tax at the subsequent death of the surviving partner on the $2 million gain as the surviving partner in a cross-purchase agreement would receive a stepped-up basis at death to the $3 million.
One of the detriments of such an agreement is that the value of the personal shares of the business are subject to the claims of the creditors. In addition, if there are three partners, there could be as many as six life insurance policies required, and 12 policies if there were four partners involved. That aside, there would be disparities as to the cost of a particular amount of life Insurance coverage for a partner in their 60s in excellent health, as opposed to a partner in their 70s in not such good health. Equalizing the individual costs for a business or practice with four or more partners could be an administrative burden.
The second type of a buy-sell agreement is called a stock redemption. In this type of an agreement the mechanics work differently. Instead of the partners owning the policies on each other’s lives, paying for one another’s premiums and being each other’s beneficiary, the business is the owner, premium payor and beneficiary of each partner’s policy. This type of arrangement makes the administration easier and equalizes the different policy charges as well as reduces the number of policies required to provide the insurance coverage for several partners. It also shields the value of the shares of the business from personal creditors.
However, the detriment to that type of an agreement is severe in that at the death of a partner there is no step up in basis in the value of the business for the surviving partner’s family at their passing. Using the prior example, if the initial value of the business or practice was $1 million and then over 20 years later, upon the death of the first partner, the value of the business was determined to be $3 million, the estate of the surviving owner would be required to pay a capital gains tax of $2 million with a basis of $1million rather than the $3 million it would have been with a cross-purchase agreement.
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Buy-sell agreements frequently utilize life insurance to provide the funding mechanism for payment of the purchase price upon death, disability, retirement or a specifically mentioned triggering mechanisms outlined in the buy-sell agreement such as divorce, unresolvable differences or bankruptcy. This source of funding is designed to have the surviving partner receive the tax-free death benefit in the most tax efficient manner, which would then be used to purchase the shares of the deceased partner from their family.
Since we’ll be focusing on the use of four different types of life insurance, a brief explanation of each type of life insurance policy that could be used is in order. Term life Insurance can be purchased with a five- to 40-year term of coverage where the death benefit, the premium and the duration of coverage are all guaranteed. Term insurance provides a death benefit only and is the most popular and least expensive type of coverage simply because the coverage contractually ceases to exist at the ages of 80-82. As a result, only 2% of term insurance coverage is ever paid out as a death benefit. However, for business owners who intend to retire or sell their business or practice before the age of 80, and only want to be protected in the event of death, term insurance is a good choice. Since a disability is more likely to occur than a premature death, it’s a good idea to address a disability by funding it with a disability buyout policy.
If one wants to guarantee their coverage beyond age 82, they can utilize a guaranteed universal life insurance policy, which for a higher annual premium can guarantee the death benefit, cost and duration of coverage up to age 120. It should be noted that the longer one wants their coverage guaranteed to last, the higher the cost.
For those business owners and partners of a practice that want to utilize life Insurance for its living benefits as well as its death benefit, they can use a whole life policy with a guaranteed premium and tax- free death benefit, based on a fixed return. Another option would be a variable life policy. This type of policy’s return is based on the returns of the stock market and is not guaranteed but may provide a higher or lower return. In either case, in addition to having provided an income tax-free death benefit during the partner’s working years, the policy could have accumulated a significant build-up of tax deferred internal cash value. Then at retirement (beyond age 59 and a half) when the death benefit is no longer needed, the partners could begin withdrawing the policy’s cash value to supplement their retirement on a 100% tax-free basis, utilizing a strategy of loans and withdrawals that never have to be paid back as long as the policy survives the Insured. This and other split-dollar arrangements (such as premium sharing) are an extremely popular strategy for those businesses with an adequate cash flow. This is known as a private pension. or supplemental owners retirement plan.
Similar steps can also be taken to ensure a key employee remains in the business during any such turbulent times by providing them with a deferred compensation plan. Such a plan can merely provide a death benefit only using simple term insurance, or arrangements can be made to use a whole life or variable life insurance policy that in addition to providing a death benefit, also accumulates cash value on a tax-deferred basis. This accumulation can, upon the key person’s retirement, be used to supplement their income with tax-free distributions, but only if they fulfill their end of the bargain, i.e., remaining at their place of business for a specified number of years set at the owner’s discretion. This strategy is commonly called a supplemental executive retirement plan.
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