There are many different reasons that you may wish to consider using life insurance to fund a buy sell agreement. On its own, a buy sell agreement is an extremely important component of planning ahead for a business. When you do not take the time to put together a buy sell agreement, the sudden departure of any individual involved in the business can raise serious questions or even legal disputes.
This is why it’s recommended that you put together a buy sell agreement as soon as possible after you have started a company. Any closely held business faces serious risks of an owner retiring, becoming disabled or passing away. A business owner’s disability or death can generate many different problems, jeopardizing the financial stability of the company as well as many years of investment and hard work.
This can also put beneficiaries in the extremely difficult position of having to sort things out on their own. Business owners left behind after the departure of a key stakeholder could be facing numerous different questions, including:
• Who will now be responsible for controlling the business?
• How will the business continue?
• Will family members of the disabled or deceased owner need to get involved?
• How will any continuing owners handle the buyout of the owner who’s no longer there?
One of the most important tools that you can use in this process is a properly drafted and funded buy sell agreement. This provides for the orderly business transfer when an owner gets divorced, retired, becomes disabled or passes away.
Buy Sell Agreements Help to Prevent Legal Disputes and Confusion
When an owner suddenly needs to depart of the business or passes away, the individuals remaining in charge will have a lot of questions to answer. It’s very easy for the business to be impacted in the short term, but it’s also a negative experience when there is no buy-sell agreement. When there are no articulated options for handling the business after an owner departs, it could generate a long-standing legal battle. This is usually not in the best interests of anyone, especially as the business continues to decline. In the worst case scenarios, the company may even have to close or file bankruptcy.
Remaining business stakeholders or family members might also face challenges in terms of figuring out the future direction of the business. If individuals cannot agree on the direction for the business to take, it could lead to months or years of legal battles. Obviously, this is not in the best interests of the business, either. Legal battles can significantly drain financial resources and take up a great deal of time and energy. Most of this can be avoided completely by articulating the future plans with a buy-sell agreement.
Your buy-sell agreement can help to plan the guidelines for how these key decisions will be made so that remaining family members and managers have the appropriate tools to determine what’s next. A buy-sell agreement outlines the options so that no one feels trapped in the situation where a business owner suddenly departs. A buy-sell agreement is like a road-map that gives key individuals the opportunity to avoid future legal problems and issues.
Benefits of Buy Sell Agreements Funded with Life Insurance
There are numerous different benefits for using life insurance as the vehicle for funding a buy sell agreement.
• Maintaining business closeness by restricting stock transfer to family members, pre-approved groups of non-owners or other owners.
• Clearly establishing the value of the stock for estate tax purposes or the purchase price of the deceased owner’s interest.
• Creating an official market for a shareholder’s closely held stock at the owner’s death or at another time when it is needed.
• Preventing transfer of stock for an S corporation to an ineligible shareholder.
• Helping to provide for an owner’s family financially in the event of death or disability.
• Potentially improving the credit risk rating of the business because the probability of business continuation has improved.
• Initiating the funds needed for a down payment on buy out at the owner’s retirement.
• Allowing for liquidity to pay the IRS estate taxes as well as other estate settlement costs.
How Life Insurance With a Buy Sell Agreement Works?
A business continuation plan on its own is an essential part of an insuring that a client’s business stays intact on retirement, another triggering event or death. Whether owners leave the business by chance or by choice, they can still help to keep the business on track and set it up for a successful future as well as providing for their own family’s future with a buy sell agreement.
Many of the benefits of using life insurance to fund a buy sell agreement have already been discussed. The policy owner in this situation will typically use policy proceeds to buy out the business interests of another owner who becomes disabled, retires or passes away. In the event that an owner decides to retire, the life insurance policy’s cash value can be accessed via partial withdrawals and policy loans in order to provide the down payment necessary to fund a buy out of his or her share of the company. Taking loans and withdrawals allows an individual to access cash values from the policy.
This may generate income tax liability and reduce the death benefit for the policy, cause the policy to lapse, or reduce available cash value. It is important to carefully consider all the implications of going this route well in advance. A properly constructed buy sell agreement anticipates how a business’s value can change over time and allows for appropriate adjustments in the amount of the buyout price. The amount of life insurance selected in the policy can be designed to vary with the potential buy out price so that a client is always properly covered.
How to Fund a Buy Sell Agreement?
A buy sell agreement relies on a funding mechanism to ensure that money is available to carry out an agreement if a triggering event occurs. Doing so minimizes the financial hardship faced by involved parties. If there are no funds available to purchase a deceased owner’s interests, the most accurately drafted buy sell agreement may not even be helpful. Although there are other funding methods outside of life insurance that may be available, they each have disadvantages.
• When a business owner appears to be uninsurable, he or she may choose to use a sinking fund. There are challenges associated with this approach, however, because it can take years to generate the funds necessary and other triggering events or the death of an owner can happen at any time. Sinking funds are also known for being expensive because deposits are used with business after-tax dollars or personal funds. Income taxes can also minimize earnings on the fund.
• Borrowing money from a third party can mean that the total amount paid for the company is much higher than the purchase price because the final cost is dependent on the length of a loan in the interest rate. A lender might also not be willing to lend funds to a business at the time that those funds are needed such as when an owner dies.
• Using current working capital funds to put together an installment buy out could significantly impact the company’s ability to carry on. It can also be very expensive because every dollar paid for business interest is non-deductible and comes from after-tax money. These payments would also stop if the business were to fail, which is why using current working capital is usually not a viable solution.
Tips for Using Life Insurance to Fund a Buy Sell Agreement
One of the primary reasons that life insurance is so popular for buy sell agreements is that it is the least expensive method in many cases. This also is a good tool to use because it makes the funds necessary for a buyout available at the time when the funds are needed the most. Some of the biggest benefits associated with this include:
• Providing cash immediately available to surviving owners or to the entity in order to purchase a deceased owner’s interest.
• Death benefits received from life insurance policies are usually income tax free.
• There are many different life insurance products available to meet the funding need.
• Substantial down payments can be generated by cash value accumulation.
• There is no financial pressure placed on the buyer at the time of purchase.
Ideal Product Features to Look for in a Life Insurance Policy to Fund a Buy Sell Agreement
Speaking with your life insurance agent about all of your options is strongly recommended but there are several different features you should consider purchasing if you plan to move forward with life insurance coverage for a buy sell agreement. These include:
• Flexibility
• No maturity or extended maturity
• Adjustable term riders or scheduled term riders
• Long term performance
• Near zero net cost loans or zero cost loans
• Potential for cash value accumulation in early years
Consult with your insurance agent today to learn more about how this type of policy can benefit you, your business and your heirs.
As you can see, there are numerous benefits of using life insurance to fund a buy-sell agreement. Although there are other options for funding a buy-sell agreement, the other options are usually not as effective and can have their own disadvantages. Before committing to a method, make sure you look into using life insurance to support a buy-sell agreement. Doing so could help avoid many different kinds of legal issues and stress on the remaining individuals or the business when someone suddenly leaves the company. With a buy-sell agreement funded by life insurance, key stakeholders have the chance to determine what to do.
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