A buy-sell agreement is a contract created by business owners to help ensure that if one of the members passes away—or becomes disabled or retires—then that person's ownership interest will be sold to the remaining partners or to the company. A life insurance buy-sell agreement requires the business owners to carry life insurance that benefits each other or the business, so that the proceeds of the life insurance policy will be available to pay for the deceased member's ownership interest.
How a buy-sell works
A buy-sell agreement states that if a member retires or becomes disabled, the exiting member must sell their ownership to the other members or the company. The buy-sell agreement also says that if one member passes away, their estate will sell their interest in the company to the remaining partners or to the company itself. This protects the stability of the business and helps keep outsiders from suddenly having ownership interests in the company.
Types of buy-sell agreements
There are several ways to structure a buy-sell agreement for your business, each of which can be backed by life insurance:
- With a redemption agreement—also known as an entity-purchase agreement—the company buys back the ownership interest of the exiting owner.
- When the remaining owners purchase the exiting owner's share, it is called a cross-purchase agreement.
- A hybrid, or combination, agreement provides additional flexibility as to who purchases the exiting owner's share: the company or the remaining owners.
When there is only one owner of a company, a one-way buy-sell agreement can be set up, where a designated buyer pays for a life insurance policy on the owner. If the owner dies, the proceeds of that policy allow the buyer to purchase the business.
Using life insurance with a buy-sell agreement
Life insurance is used to fund buy-sell agreements should an owner pass away. Each business owner must take out a life insurance policy with the other members or the company as the beneficiary. The face amount of the policy is equal to the value of that member's ownership interest. Should that member die, the policy pays out to the company or remaining owners, providing the funds they need to purchase the deceased member's share.
Tax issues with life insurance buy-sell agreements
The company itself may pay the cost of the life insurance on each owner. The premiums are not tax deductible for the company, nor are they considered taxable income for the individual members.
There is no tax applied to the payout of the policy, unless it is payable to a C corporation, in which case the minimum alternative tax may be triggered.
Why a buy-sell is important
Buy-sell agreements provide stability for a business. If one owner leaves, no one new can buy that person's interest. Instead, it has to be sold to the remaining members or to the business itself. This provides security to the owners and helps ensure that there will be continuity of ownership. The buy-sell agreement also guarantees liquidity to all of the owners. If they need to sell and exit the business, they can, and the value of their ownership interest is clearly established.
When you create a buy-sell agreement for your business, you want to be sure it is done correctly and is legally binding. Consider working with an attorney or online service provider to create one. A life insurance buy-sell agreement can ensure stable ownership of your company despite what may happen to the individual owners over time.
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