Buy-Sell Agreements: What Happens If an Owner of a Closely Held Business Dies or Is Disabled?

Shareholders and business partners in closely held businesses should be aware of the possibility that one of their partners may die early or become permanently disabled. The estate of the deceased may stipulate that the business be passed to the family. This could cause serious problems for the business and its surviving partners. Sometimes, businesses that were once successful are forced to sell or have their assets taken by creditors. This problem can be solved by buy-sell agreements. They provide the business with the cash needed to purchase the family’s interest in the business.

Two types of buy-sell agreements are common, which I will discuss in this article. Cross-purchase agreements are where one shareholder or partner buys life insurance policies on behalf of the other shareholders or partners. Cross-purchase agreements are great for small corporations or partnerships with two or fewer shareholders. Cross-purchase buy-sell agreements can be difficult to manage in cases where more than two people are involved. For example, three shareholders or partners will need six policies (three each buying two policies each); five partners will require twenty policies (five each purchasing four policies each). These numbers rise quickly, as you can see. Further complicating matters, buy-sell Disability Insurance (DI), policies that purchase a partner with a disability, can be used to buy out the other share of the business. This will double the number if DI policies are included. Due to the fact that both life and DI policies are rated based on age and health, there may be large differences in the premiums paid by each partner. Taxes can also be a factor: If the partners have a lower tax rate than the corporation the cost of funding may be higher than cross-purchase agreements.

An alternative to a cross-purchase arrangement is a stock redemption. In this agreement, the corporation holds the insurance policies for each partner. The insurance policy gives the corporation the ability to purchase the partner’s interest in the business if a partner is incapacitated or dies. The corporation is the owner of the insurance policies. This makes administration easier than cross-purchase agreements. The business is responsible for underwriting differences that impact premium, rather than creating dissimilarities in the cost of insurance for each partner. Stock redemption agreements have one problem: the shareholders who remain do not receive an increase in basis value, but they retain the original basis price of the shares. If shares are sold prior to death, partners will be responsible for greater capital gains as a result of the stock redemption structure. If the stock redemption is completed, each owner will now have a greater share of ownership. You can also use a hybrid approach to structure your agreement, which allows you to combine cross-purchase with stock redemption.

Other tax implications exist that go beyond the scope this article. It is important to note that tax implications of these insurance agreements must consider tax implications based on the level of complexity the partners are willing and able to accept. To find the best solution given the tradeoffs involved, it is important that the partners work together with their attorney, accountant, and insurance agent.

What happens if one of the partners is not insured? If the partner has life insurance or DI policies, they can transfer the ownership to the business (stock redemption) or the partners (cross-purchase). The cash surrender value of a life insurance policy that is cash-value will be paid to the partner. Tax implications are also important. Partners should consult their attorney and accountant to properly structure the arrangement.

You can choose to use cash value or term insurance for your buy-sell agreement. Both have their advantages and disadvantages, just like individual policies. Annual Renewable Term (ART), policies offer low upfront costs but rise with the partners’ ages. The cost structure of level term policies is predictable. However, they expire after a predetermined time period. This can be ten to twenty years depending on the type of policy purchased. The policy holders will need to go through underwriting again once the term ends. However, because they are older, this will make it significantly more costly and increase the risk that one or more of their partners might not be able get insurance. The risk in this case can be reduced by purchasing a guaranteed insurance rider. However, it increases the policy’s cost.

Whole Life (WL), and Universal Life (UL), are cash value policies that have the advantage of building cash values and can be self-funded as soon as the dividends generated exceed the premiums. The policies can be continued to be funded, with the cash value being used to supplement or fund pension benefits and shareholder buyouts. The cash value can also be used to obtain favorable loan terms for the company because it is considered a liquid asset.

If they feel that the cost of insurance is more than the potential for higher capital appreciation, the partners may decide to cancel any buy-sell agreement. The partners might decide that the risk of a partner’s premature death or disability is low enough to make it worth their while to reinvest the money in the business to get a higher rate return than what the insurance policies can provide.

Due to the complexity of buy-sell arrangements, it is important that an experienced agent as well as a business’ attorney and accountant be hired to help structure the agreement so that it best meets the needs of the business, the partners and the surviving family members. The partners must decide if a buy-sell agreement is necessary and, if so, how to structure it from a tax and cost perspective. This is a difficult decision. Expert advice will make it much easier and less stressful.