Buy-Sell Agreement: Protecting Your Business With Life Insurance
Life insurance is designed to help protect a household from the financial hardship that can follow the untimely death of a primary wage earner. But how does a death — or disability — affect a small business?
One way to safeguard a business is to put a buy-sell agreement in place.
A buy-sell agreement is a contract between the owners or entities within a company that establishes how the interest of a deceased or disabled owner will be bought out. Beyond the ownership transfer itself, a buy-sell agreement can also help:
- Protect the business from lost revenue during the transition
- Cover the cost of finding and training a replacement
Types of Buy-Sell Agreements
There are two main types of buy-sell agreements used by businesses today.
Cross-Purchase Agreement
In a cross-purchase agreement, the remaining key employees or owners have the right to buy the ownership interest of a deceased or disabled key employee. Each key employee typically holds a life insurance policy on each of the other key employees to fund this purchase.
Cross-purchase agreements tend to work best for smaller companies with a limited number of key employees to cover, since the number of policies needed grows quickly as more owners are added.
Stock-Redemption Agreement
A stock-redemption agreement is a formal agreement between all key employees and the business itself. Under this structure, the business — not the individual owners — agrees to purchase the shares of a deceased key employee, often in exchange for a predetermined cash value.
Both types of agreements help establish a clear, agreed-upon market value for each key employee’s share of the company ahead of time, rather than leaving that determination to be worked out during a difficult transition.
Funding a Buy-Sell Agreement
Once a business buy-sell agreement is in place, the next question is how to fund it. There are three common approaches to funding a buy-sell agreement:
- Set aside funds. Money can be reserved specifically for this purpose, as long as it stays easily accessible. These funds need to be maintained for the life of the company, which can create a temptation to dip into them during financially difficult periods. Owners must also determine the right amount needed to cover a full buy-out.
- Borrow the needed amount. A company can borrow funds to buy out a key employee’s interest at the time of death or disability. However, losing a key employee can make it harder to secure financing, and loan payments add financial stress to the business during an already difficult time.
- Life insurance. Purchasing life insurance — or buy-sell agreement insurance — to fund the agreement is a common forward-looking option. Using life insurance for buy-sell agreements allows the arrangement to be funded through ongoing premium payments, helping ensure funds are available exactly when they’re needed.
What to Know About Buy-Sell Agreement Life Insurance
Several factors affect the cost and availability of a life insurance policy used for buy-sell agreement funding, including:
- Age
- Health
- Type and amount of insurance purchased
A few additional considerations:
- Life insurance policies carry expenses, including mortality and other charges.
- Surrendering a policy prematurely may result in surrender charges and income tax consequences.
- Insurability should be confirmed before implementing a life insurance-funded strategy.
- Any guarantees associated with a policy depend on the claims-paying ability of the issuing insurance company.
For Southwest Florida business owners, working with a local financial professional who understands both business succession planning and insurance funding options can help determine which buy-sell structure — and which funding method — fits your company’s situation.
Frequently Asked Questions
What is a buy-sell agreement?
A buy-sell agreement is a contract that outlines how a deceased or disabled owner’s interest in a business will be bought out, helping protect the company from lost revenue and the cost of finding a replacement.
What’s the difference between a cross-purchase agreement and a stock-redemption agreement?
In a cross-purchase agreement, individual key employees buy out a deceased or disabled owner’s share and typically hold policies on one another. In a stock-redemption agreement, the business itself buys out the shares directly from the owner or their estate.
How is a buy-sell agreement typically funded?
Common funding methods include setting aside dedicated funds, borrowing the needed amount at the time of a triggering event, or using life insurance to fund the buy-out through ongoing premium payments.
Why use life insurance to fund a buy-sell agreement?
Life insurance can help ensure that funds are available exactly when needed, since the buy-out is funded gradually through premiums rather than requiring a large lump sum or loan at the time of an owner’s death or disability.
Is a buy-sell agreement only for large companies?
No. Cross-purchase agreements are often well-suited to smaller companies with fewer key employees, while stock-redemption agreements can work for businesses of various sizes.
This content is developed from sources believed to be providing accurate information. It is not intended as tax or legal advice and may not be used to avoid federal tax penalties. Please consult a legal or tax professional for guidance specific to your situation. The opinions expressed and material provided are for general information only and should not be considered a solicitation for the purchase or sale of any security.
