Life Insurance Planning with Buy-Sell Agreements
THE NEED FOR PLANNING
Buy-Sell Agreements can best be described as rights and obligations relating to business ownership granted and assigned to partners upon the occurrence of a triggering event. Although it may at first seem that business partners have mirrored interests as it relates to ownership, it is upon the occurrence of a life-changing event where those interests sharply diverge. For example, a partner who becomes totally and permanently disabled may prefer ongoing income associated with ownership. However, the non-disabled partner may want to have the right to purchase the shares to consolidate ownership and protect the company from any future financial difficulties the disabled partner might incur. When identifying the issues to consider when preparing a buy-sell agreement, every partner need to ask the following questions:
What sort of triggering events should be included in the agreement?
What rights and obligations should each partner have after a triggering event occurs?
How will the value of the business be determined at the time of a triggered transaction?
What funding mechanisms will be in place to provide the seller as much liquidity as possible upon a sale?
If the above-mentioned funding mechanisms are not adequate, what are the terms of the note the seller will have to carry?
As discussed below, life insurance plays an important role in the creation of buy-sell agreements, primarily in the last thee issues mentioned above. But first, lets address some of the other equally-important considerations.
Triggering Events. At its most fundamental structure, a buy-sell agreement has death as a triggering event. Occasionally we will see agreements where death is the only triggering event, but such brevity is short-sighted. Disability should also be included with a distinction made between whether the disability is temporary or permanent and whether it is a complete or partial disability. Other triggering events which should be included are the insolvency (due to bankruptcy, legal problems, etc.), divorce (especially with California being a community property state), and even instances of professional discipline and/or negative public relations (e.g., a CPA would want to distance himself from a partner who is being charge with embezzling money from a charity.)
Valuation. As stated earlier, upon the occurrence of a triggering event, the partners' interests sharply diverge with the purchasing partner wanting a low sale price with the selling partner obviously wanting a high one. It is important to consider that the agreed upon valuation may not have anything to do with the fair market value. (In these situations consideration needs to be given to tax implications if there is a disparity between the two). For example, the partners may agree on a flat amount which may or may not adjust for inflation. There may be some sort of formula (i.e., book value or a multiple of EBITDA). Or most common is some sort of process to get the business independently appraised with a valuation expert chosen by all interested parties. (Or in the alternative, multiple appraisers chosen with the resulting values averaged).
Funding. It is very rare that one is independently able to fund the buy-out of his or her partner. The goal when it comes to funding is to build into the agreement a source of liquidity from which the purchasing partner can use for the purchase. When that liquidity is insufficient (or non-existent) then the seller will have to carry an arm's length note. Although death is only one of the many triggering events that should be included, given its central focus, life insurance is, in many cases, by far the best funding mechanism.
Fundamental Structure (Agreement Type). When it comes to the fundamental structure of a buy-sell agreement, there are three primary options; all depending on how the life insurance is owned and who the buyer(s) will be. In a "cross-purchase" agreement, each partner purchases a policy on the life of every other partner. When one partner becomes deceased, the surviving partners have the liquidity to purchase the interest. In a "stock-redemption" structure, the business itself owns a single policy on the life of each of the partners, with the business itself purchasing the shares of the deceased partner. The last structure is the "wait-and-see" structure which gives the company right of first refusal, and if not exercised, the other partners will have the right. If the partners do not exercise their option then the company would be required to make the purchase. In a wait-and-see structure, there is a tremendous advantage to the partners creating a separate partnership to purchase one policy on each of the partners. This "life insurance partnership" is discussed below. It should be noted that there are a myriad of tax considerations that need to be looked at and not just the convenience of life insurance policy ownership (which is often erroneously considered the only factor).
WHY LIFE INSURANCE IS THE PREFERRED FUNDING MECHANISM
Low Cost. Paying life insurance premiums is a great way to leverage those dollars with the payout being many multiples of what was put in. With business ownership typically having an anticipated end date (i.e., most business owners eventually sell), lesser expensive term products make this option even more affordable
Simple. Life insurance as a funding mechanism is just as easy to understand as it is to explain. Clients feel comfortable about it and all parties are usually able to wrap their brains around it fairly quickly. And by definition, life insurance is the only means which guarantees liquidity at death--the very event it is needed.
No Adverse Effects on Company Financials. In many instances, (especially with a cross-purchase structure,) the policies are held outside of the books of the business and therefore have little or no bearing on its working capital or creditworthiness.
Expeditious. The unexpected death of a business owner can be just as catastrophic for the business as it is for the family. With life insurance death benefits usually paying out quite quickly, business continuity is ensured as well as rapid income replacement for the family.
Product-Specific Flexibility. Certain riders can be added onto various products resulting in greater flexibility. For example, a chronic illness rider allows the acceleration of a death benefit, and can be used to buy out a chronically ill partner.
THE LIFE INSURANCE PARTNERSHIP: REDUCING COSTS WHILE BUILDING EQUITY
Life Insurance Partnership Structure. A life insurance partnership begins with the creation of an LLC or S-Corporation. That entity is then funded with assets resulting in sufficient resources to purchase a policy on the life of each of the partners. The partners are also co-owners in this partnership. When one partner dies, the partnership then has the liquidity to purchase the deceased partner's shares. The many advantages of this structure are addressed below.
Making Life Insurance and Asset Rather Than a Liability. The life insurance partnership can choose to purchase cash-value accumulation policies on the partners instead of more traditional term policies. As the policy cash value accumulates it becomes an asset for the benefit of the partners, which can be used for retirement income or simple wealth accumulation. The cash value can also be used as a sinking fund providing liquidity for a lifetime buyout, thus expanding the capability of life insurance to beyond just death as a triggering event.
Tax Benefits. A life insurance partnership has multiple tax benefits. First, it can be structured so that the policy and any other assets are excluded from the gross estate of each of the partners. Furthermore, a step-up in basis is typically only available in a cross-purchase structure. As alluded to above, a cross-purchase structure becomes cost-prohibitive very quickly when the number of partners exceeds three or four. So, in situations where the number of partners becomes numerous, the stepped-up basis advantage can still available.
A NOTE ON TAX PLANNING AND WORKAROUNDS
Quite often workarounds are implemented to accomplish a buy-out but with the intent to facilitate a certain aspect or objective of one of the parties; sometimes at the expense of another. One that we most often see if the continuation of employment of the seller, or some sort of consulting agreement where payments continue, but the expectation of involvement does not. These types of arrangements almost always have to do with tax avoidance, but are rarely properly analyzed. For example, when a seller signs on as a contracted consultant, the payments made are tax deductible to the business (whereas note payments on the purchase of the interest are not). However, the income received is taxed at ordinary income rates as opposed to the much lower capital gains rates that would be paid on note payments. Without grossing up the payments to result in a mutually desirable net amount, this puts the buyer in a preferred tax position at the expense of the seller. However, this advantage may also be an advantage for the seller as the preferred position can also mean more stability and a higher likelihood of the business's continued ability to pay. Regardless of how commonplace these types of arrangements have become, it is imperative to recognize the potential for a misrepresentation of facts before the IRS, and that a sale--even between family members, needs to be an arm's length transaction.
**Note that many considerations relating to buy-sell agreements and life insurance (primarily specific tax considerations) were intentionally omitted from this post as such was beyond the scope of a general overview. Please feel free to contact us should you have any additional questions.