Would your business survive if one of the owners died? Consider Doug and John, owners of a bakery. Doug is an expert at cakes and pastries, while John’s talent is rolls and breads. They both share the load of administrative work, with Doug taking care of accounting, and John’s responsibilities include marketing, sales and payroll. If Doug were to die prematurely, John would likely have to hire two or more employees to fill Doug’s shoes. At the same time, Doug’s widow has young children that she needs to provide for and finds herself in desperate need to sell Doug’s share of the business to meet her family’s needs. John can hardly run a profitable business under such conditions, much less raise the funds to purchase Doug’s share of the business from his widow.
Such situations can be avoided with properly drawn and funded buy-sell agreements. The best time to prevent a business disaster is before it happens. Henssler Financial encourages business owners to consider the implementation of a buy-sell agreement as part of their business plan. Buy-sell agreements allow owners to establish a predetermined price at which the business can be bought by the surviving owner(s) should an owner die. These agreements are often funded by life insurance policies, where the proceeds from the death benefit allow for the purchase of the deceased’s share of the business. In our example, a buy-sell agreement would allow for an easy exchange of business ownership to John, while providing Doug’s family with money from the sale of his business interest.
There are essentially two types of buy-sell agreements: cross-purchase and entity. In a cross-purchase agreement, each owner of the business purchases a life insurance policy on the life of the other owner(s). Each owner pays the premiums on the policies to the insurance company, and is named the beneficiary. When an owner dies, the insurance company pays the death benefit to the surviving owner(s). In turn, the proceeds are used by the surviving business owner(s) to purchase the deceased’s share of the business at the previously agreed upon price.
Cross-purchase agreements are commonly used when there are a small number of owners. The plan can become difficult to administer if there are several owners. For example, if a business has seven owners, a cross purchase agreement would require 42 policies, as each owner would purchase a policy for each of the six other owners. Another obstacle owners may face is insurability creating a difference in premiums. Younger or healthier owners may incur higher premiums to cover older or less healthy owners.
In entity agreements, the business purchases a life insurance policy on the life of each owner, with the business paying the premiums. When an owner dies, the insurance company will pay the death benefit to the business. The proceeds are then used by the business to purchase the deceased’s share at the previously agreed upon price, with surviving owners now enjoying a greater percentage of ownership. This type of agreement is commonly used if a business has more than two owners. The administration is relatively easy, and the business bears the premium differences associated with owners’ insurability.
Overall, the buy-sell agreement gives everyone comfort and security that they will receive maximum benefit from the business that they worked a lifetime to establish. While it is possible to come to an agreement on how business interests should be bought or sold if an owner dies, a buy-sell agreement is most effective if it is properly funded. In both cross-purchase and entity agreements, life insurance plays a key role in providing funds to buy the deceased owner’s business interest. Using life insurance in this manner may be cost effective, easy to fund and easy to understand.
However, there are several other “what ifs” that need to be considered when business owners establish a buy-sell agreement. Other scenarios you may want to consider include:
- Is there a buy-sell agreement in place for a disabled owner?
- Should the death of an owner cause an automatic buyout of the owner’s interest, or should the surviving family be allowed to remain as an owner?
- Should the agreed upon price reflect that you are selling to a long-time business associate rather than selling to an outsider for profit?
- Can part of the life insurance policy proceeds be used to help the business recover from the loss of an owner?
- What are the tax implications for the owners or business of a cross-purchase versus an entity plan structure?
For more information on buy-sell agreements, contact Henssler Financial at 770-429-9166 or [email protected]. We can examine your business to determine whether a buy-sell agreement would be beneficial to your business. We can also assist coordinating a buy-sell agreement with your estate planning attorney and tax consultant.