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Taxation and Business Uses of Insurance - Business Uses of Life Insurance

BUY-SELL AGREEMENTS
Owner's of a closely held business need to consider how the ownership of their business is to be transferred upon certain life changing events. Business succession planning is a key element of any business owner's financial plan. There are several key elements to consider when creating a business succession plan. One of the more common ways to transfer ownership is through a buy-sell agreement between business owners. Most often this agreement will serve as the key element to any succession plan.

Definition
A contractual agreement outlining how the ownership of a business is to be transferred upon one or more of the following events:

  • Retirement
  • Death
  • Disability
  • Bankruptcy
  • Divorce

Typically, the ownership is transferred through the sale of interest in the company. The price of the sale is determined by a formula outlined in the contract.

Advantages of a Buy-Sell Agreement
There are many advantages to this type of agreement. When selling interest in a business, it is difficult to guarantee that a market will exist. When there is no market for the sale of a business the owner or the owner's family will have to retain the interest. This can create an unwanted burden for the family or withdrawing owner. Also, in the instance of the death of an owner a large estate or death tax liability may exist. A buy-sell agreement creates liquid assets available for the payment of the estate or death tax. The agreement can also establish the value of an owner's business interest thus, easing the estate planning process. Most importantly, an agreement will guarantee the proper continuation of the business. This decreases the overall risk taken by the owner's of a business, increases a businesses credit rating, and makes the business more favorable to would be investor's.

Practice Question:
Bobby is one of three owners in ABC Corporation. All three owners have equal interest in the business. The owners have decided to establish a cross purchase buy-sell agreement funded with life insurance. According to the contractual agreement the business is worth 10 million dollars. How many life insurance policies will Bobby need to purchase and how much life insurance must he purchase on each owner to fully fund his portion of the agreement?

A. 1; $10,000,000
B. 1; $3,333,333
C. 1; $1,666,666
D. 2; $3,333,333
E. 2; $1,666,666

Answer: E
Bobby would need to purchase 2 policies (one for each owner other than himself). If the value of the business has been established as $10,000,000 each owner owns $3,333,333 of the business. If one of the owners was to die their family would need to receive $3,333,333 for the value of his/her share. Therefore each owner must buy 2 policies valued at $1,666,666 (2 * 1,666,666 = $3,333,333) a piece.

Structure and Tax Considerations of Buy-Sell Agreements
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