What is a Buy/Sell Agreement?
Because partnership organizations involve co-ownership of a business, buy-sell agreements are drawn up to clarify each partner’s monetary share of the business and how much it would cost to buyout the other partner.
Buy-sell agreements also allow an owner to exit the business, if they so choose, and requires their partner to purchase the share at the agreed percentage.
There are usually clauses in place that allow for amicable parting, if an owner wishes to exit. For example, if an owner just wants to exit for no reason, it would be fairly unreasonable to force the other partner to come up with enough money to purchase the share with little notice. There would usually be a clause that gives a partner sufficient time to come up with the money or even the ability to purchase at a discount.
What happens if a partner dies?
Problems may arise if a partner passes away. The partner’s family may not know what to do with the business share; or the surviving partner may not wish to work with the deceased partner’s family. Buy-sell agreements contain a death clause that allow the surviving partner to buy the deceased partner’s share from the family. It’s usually not enough to just buy the share. Because the family will be without the deceased partner’s income, many of these clauses also force the surviving partner to provide income replacement. This can add up to a lot of money that a surviving partner would have to come up with and could potentially kill the business. That’s where life insurance comes in.
How can you fund a buy-sell with life insurance?
Life insurance was really only designed to take care of the death clause within buy-sell agreements. But as products evolved over time, they can do much more.
Here’s an example scenario using a Return of Premium term policy.
Let’s say Joan and John, both in their late 30’s, open an accounting firm. Each has a 50% vested interested in the business. After a year in business, they determine that the business’s net worth is $900,000 when assessing their current assets and net income for the year. Through legal preparation for the next fiscal year, Joan and John adopt a buy-sell document, establishing ownership percentages and equity purchase clauses for partner departure and death.
They agree that if one were to depart, the departing partner could sell their share of the business to a new partner or sell it to the staying partner at a discount.
Their death clause states that the business must be purchased by the surviving partner for today’s full equity value plus $200,00 (to simulate 4 years of an average $50,000 salary) from the deceased partner’s family. They want this death clause in place because neither want to deal with the complications of involving the dceased partner’s family.
For retirement departure, they both mutually agree that at age 70 they will fully retire and sell the business.
If Joan and John each purchase a $650,000 Return of Premium policy on eachother, with a 30-35 year term length, the death clause is taken care of. It pays for the share of the business and provides $200,000 of income to the deceased partner’s family.
If both Joan and John reach age 70, the life policy will end and the entire premium payments will be returned to each partner. They can sell the business and retire.
But let’s say John wants an early retirement at age 60. He can choose to exit, sell his share to Joan at a discount, and cancel the life insurance. Even though the policy wouldn’t reach the end of the term, it still would have built a decent cash sum that John could access.
What if my business is a corporation, or has multiple partners?
In these cases, the same funding process is utilized, but on a slightly larger scale. This type of a buy-sell agreement is referred to as a cross-purchase agreement.
Let’s say you get involved in a business with 4 other owners (you become the 5th owner). A $1 million dollar business would give each owner a $200,000 vested interest (in a perfect world). In this case, if one owner died, $50,000 ownership would go to each surviving owner. This would mean that you would want to have a $50,000 life insurance policy on each owner in order to buy part of the deceased owner’s share.
Beneficiary designation is extremely important, and requires careful review, when setting up life insurance to support a cross-purchase plan. This is because simultaneous deaths from a common event is a possible occurrence that could cause significant confusion. It’s essential that contingent beneficiaries are listed correctly for every policy. Even veteran agents make mistakes on these cases.
Here’s an example of how one policy should look:
- Coverage: $50,000
- Policy Owner: Partner 1
- Insured: Partner 2
- Beneficiary: Partner 1
- Secondary: All living partners in equal shares. Partner 3 – Partner 4 – Partner 5
- Contingent: If all partners are deceased in a common event, all proceeds should go to the insured’s surviving spouse and/or children in equal shares.
If each policy is set up this way, all death benefit proceeds will be divided correctly. A sole surviving partner, in our example, would receive $800,000 and could buy each partner’s share. If there are two sole surviving partner’s, they would each would receive $300,000. If there are three survivors they will receive $133,333 each. If there are four survivors each will receive $50,000. If there are no surviving partners, this plan is designed to pay the surviving families an equal amount; in this case $200,000 each. Keep in mind, the surviving families still own each respective business share. It’s fairly likely that in this extremely rare situation the families would liquidate all the business assets.
Do sole proprietors and LLCs have buy-sell agreements?
There are cases where a business owner would have a buy-sell agreement with a key employee.
Let’s say a key employee wants to one day follow in the footsteps of their boss and operate the business. If the business owner has children, in theory, the surviving children would either take over business operations or just liquidate the business. If the key employee wants to own the business, the owner and the key employee could draw up a buy-sell agreement.
Using a life insurance policy to fund the agreement, the key employee could buyout the surviving children’s interest in the business.
Finding the right insurance professional.
If you and your partner(s) are in the process of putting together a buy-sell agreement for your business, it’s essential to talk to the right insurance professional. Most agents have never helped any business fund a buy-sell agreement. Having experience for this type of insurance plan is important.
Twin Cities Mutual Life Agency has the experience to work on these cases. To schedule an appointment please visit our scheduling page.