A Buy/Sell Cross Purchase Plan or agreement is also referred to as a cross buyout agreement. Basically it is a binding agreement written by an attorney between co-owners of a close corporation, partnership, LLC or even a sole proprietorship that determines what happens if one of the owners dies. Some people consider it a “premarital agreement” of sorts between business partners. This type of “business will” is often funded with life insurance on the participating owner’s lives and recommended by business succession specialists and financial planners. The life insurance ensures that the buy/sell plan is funded and guarantees there will be money when the buy–sell event is triggered by a death of a co-owner.
The basic buy/sell cross purchase plan consists of several legally binding clauses that should be thought through carefully because it helps with the following:
- Create a market for a closely held business;
- Provide the money to fund the plan and;
- Determine a price at which all parties agree to buy and sell their business interests.
Funding a Buy/Sell Cross Purchase Plan with Life Insurance
Once the owners establish a cross-purchase buy/sell agreement with the assistance of their attorney, accountant, business succession specialists or financial planner they would purchase and own a life insurance policy on each of the other owners. The owners have the option of paying the nondeductible premiums or let the business pay the premiums, which are deductible for the business but is considered income and compensation to the insurance policy owner or owners.
The benefits received by the other owner or owners when one of the owners dies are generally distributed as tax-free income. The owner or owners would then use the proceeds to purchase the deceased owners business interests from their estate.
Advantages of using life insurance
Using a life insurance policy to fund the purchase takes the burden off the company to fully fund the buy/sell agreement as well as giving the surviving owner or owners the means to buy the business interests from the owner that has passed away. Having the amount agreed upon before the death is a way to protect the business from potential litigation from the deceased’s estate. In short;
- Life insurance creates a lump sum of cash to fund the buy-sell agreement at death
- Life insurance proceeds are usually paid quickly after death, ensuring that the buy-sell transaction can be settled quickly
- Life insurance proceeds are generally income tax free; a C corporation may be subject to the alternative minimum tax (AMT)
- If sufficient cash values have built up within the policies, the funds can be accessed to purchase your business interest following your retirement or disability
Disadvantages of using life insurance
Of course there are also disadvantages that need to be taken into consideration as well. Make sure you are fully aware of the following before considering using life insurance to fund a buy/sell cross purchase plan.
- Life insurance premiums are paid with after-tax dollars because the premiums are generally not a tax-deductible expense
- Premium requirements are an ongoing expense
- One or more co-owners may be uninsurable due to age or illness
- If the co-owners’ ages vary widely, younger co-owners will have to pay higher premiums on the lives of the older co-owners
- If the ownership percentages vary widely, more insurance will be needed to cover the owners with the larger ownership interests, resulting in higher premium costs for those with smaller ownership interests
How to set up different types of buy-sell agreements
Having a great relationship with your life insurance agent can help you determine if this is an option for you and your business. Your agent can help you set up the life insurance part of the agreement as well as go over the premiums, how they can be paid and the differences mentioned above. The agent will work closely with your attorney, accountant, financial planner or any other professional you designate to help you set this up according to your wishes.
Because the amount of insurance coverage on your life should equal the value of your ownership interest, it will be very important to get a value for the business today as well as the potential value in the future. You will need to be clear in your agreement how the business will handle the valuation difference. That way, if you die before you retire, there will be enough cash from the policy proceeds or other means to pay your estate in full for your share of the business. If this is not affordable at this time, you might want to go ahead and fund as much as you can at the moment. Your company may be able to increase the amount of insurance or use additional funding methods down the line to cover the difference. If you do it this way, you will need to specify in the agreement how your family or estate will eventually be paid in full for your portion of the business.
Make sure you discuss the tax implications with your business and personal accountants so you understand fully how this type of agreement will impact the business and your estate with taxes and other liabilities.
Keep track of your buy-sell agreement
The premiums on the policies must be paid on time no matter if it is a yearly, semi, quarterly or monthly payment, or the insurance will lapse. This means whoever takes care of the payables in your company must monitor premium payments carefully; even if the owners are paying the premiums themselves. Every buy-sell agreement should include a feature requiring ongoing proof of payment so there is a way to check and make sure everyone is paying as required by the agreement. Also, review the amount of insurance regularly. The insurance coverage may have to be increased periodically to reflect increases in the value of the business. If additional insurance is not possible, another funding method should be established.