General Life Insurance Topics
Funding Buy/Sell Agreement with Life Insurance
Not too many years ago, two brothers decided they had an idea which could make both of them very wealthy. One brother had extensive computer knowledge as to how to market commodities over the internet. He had extensive experience with convincing suppliers he could market their products with his own in-house sales force, but he had no experience with drawing up legal documents with suppliers or web site designers.
The other brother had a law degree with a specialty in contracts, leases and limited experience with international trade laws. He had done some law work for a clothing company which was attempting to go global with their products. This had given him in depth experience in property leases and exporting and importing commodities across the United States and China.
Seeing the potential by combining their fields of expertise, they drew up a business plan, presented it to a commercial bank, and procured retail office space from which they could have a store front from which they could distribute their products.
As part of their business plan, they drew up a buy/sell agreement which clarified their interests and how those interests would be handled upon the dissolution of the business from either death, disability, retirement, or bankruptcy. They both agreed at some later date they may allow others to invest in their business but to begin with the brother with the marketing and computer expertise who would handle the day to day operations would be the majority stockholder. He would control at least 70% of the business at all times with the other 30% having discretionary ownership. Since at the inception it would be just the two brothers, the unassigned 30% would be attributed to the other brother.
As is standard in a buy/sell agreement, both brothers agreed that at any time there would be an event which would or could affect the ownership percentage, either of them would have first right of refusal to purchase the stock. Using the capitalization of earning method for determining the value of their business was chosen because of its simplicity and ease of application (cash flow divided by rate of return, i.e. 100,000 divided by 8%=$1,250,000 estimated business value.) In other words, a $1,250,000 business at 8% will yield $100,000 annually.
Because of the substantial loan and the immediate financial liability it created, the brothers approached their insurance agent and purchased large face value policies on their lives. A collateral assignment was given to the bank to pay off the loan in the event of death with the rest of the face amount reserved to protect their future interest in the business.
They had several options on how those policies would be owned and paid for.
- Have the business as owner, payer, and beneficiary which would allow the business to manage all facets of the policies, i.e. method of premium payments, changing of beneficiary, use of cash value accumulations, receiving and disbursing death benefits, or termination of policies.
Payment to the life insurance company would come directly from the company and would not show up as any form of remuneration for either brother. It would not be considered a business expense since under the life insurance death benefit the proceeds would come to the company income tax free and would be an influx of a liquid asset.
The buy/sell agreement would already have the agreement on how each individual brother and wife would agree to buy or to sell in the event the business needed to make a change. The buy/sell would instruct the business on how the policies would be handled, i.e. give the owner of the business the right to use cash values for loans to the company; allow the company to use accumulated funds in the policies to help pay for a buyout if either brother decided to leave company and take his value with him upon retirement or disability; charge the company with using death proceeds to buy out deceased’s interest to surviving spouse either in a lump sum or over periodic payments, thus reducing capital gains or other taxes which may be required of deceased’s estate.
This part of the agreement would be referred to as a stock redemption plan so there would be no questions when the proceeds coming from the life insurance company were being paid income tax free to the company and then, losing its identity as life insurance proceeds, were paid out to redeem the stock of the deceased party.
This payout would still allow the same percentage of ownership to stay the same with the stock simply redeemed and owned by the company. The surviving brother would have complete control of the company and would be free to run it as he would see fit.
- Cross purchase policies with each brother being the owner, payer, and beneficiary on policy of the other. Each brother would have the obligation to pay premiums on the policy he would own. Again, the buy/sell agreement would spell out how business interest would transfer in any of the events listed above. In the event of death, the death proceeds would come directly to the owner of the deceased brother’s policy and then would by buy/sell agreement be paid to the deceased spouse to retire her interest in the business. All the stock would now be in the ownership of the surviving brother, giving him 100% of value. His stepped-up basis in the business would now be what he originally put into the business plus the amount he paid to retire the stocks of his brother.
- Each brother would own the policy on his life, pay the premium and name his wife as beneficiary. This would have no influence on the transfer of value on any of the examples listed above. The wife would maintain her inherited interest in the business and would simply step in and attempt to perform the duties of her deceased husband. One would hope the buy/sell agreement which had been written but not funded could be interpreted in such a way the wife of the deceased would use the funds in such a way that the surviving owner could have the time to pay off the deceased brother’s interest in the business. This could possibly be addressed through a sinking fund established by the brothers to pay off interest in the deceased’s estate.
One could argue that a buy/sell agreement could be funded with a term insurance policy rather than a permanent policy, but look what would be given up in that event. In the event of death, no problem so long as the policies are kept in force even as their premium continued to rise. Companies would either have to have a sinking fund valued at the amount needed to retire the stock of the retiring or disabled owner or have a credit line sufficient to cover that expense. In either event, the funds paid out would have to be paid back at 100% on the dollar to replendish the sinking fund or 100% plus interest if settlement was reached through borrowing the funds.
Another positive of using permanent life insurance is that the cash value of the policies show up as an asset on the company’s balance sheet. Those same cash values could be used to purchase inventory or capital improvements and could be paid back at rate favorable to company. The interest the insurance company would charge for the use of the cash value would generally be less than what would be required for a banker to charge for the same use. Also, in tight economic times the bank may not enter a loan agreement with the company, where the life insurance company by contract makes the amount of the cash value available at any time after cash values begin to accumulate at a rate established when policy was written.
In conclusion, going into business with another has tremendous positive upsides, but it also creates issues not dealt with under a sole proprietor form of ownership. Having the ability to communicate with sound legal counsel can go a long way in alleviating the downsides of different types of business ownership, and having access to good financial planning can even further remove the stress associated with doing business.
The two brothers after being in business together for several years chose to sell the business to another entrepreneur and, according to the directions they spelled out in their buy/sell agreement, settled up. One went on to start another upstart business, and the other went back into legal practice doing what he does best without the stress associated with trying to make a business survive in the marketing environment. They both agreed it was the directions spelled out in the buy/sell agreement that made the transition easy and allowed them to leave on such friendly terms.