A Buy/Sell Redemption Plan using life insurance to fund it is very similar to a buy/sell cross purchase plan because the funded plan utilizes the proceeds from life insurance to effect the orderly change of ownership of a close corporation, partnership or LLC at the death of a stockholder, partner or member. Also, like the basic buy/sell cross purchase plan, this helps with:
- Creating a market for a closely held business;
- Providing the money to fund the plan and;
- Determining a price at which all parties agree to buy and sell their business interests.
How the Buy/Sell Redemption Plan Works
The owners and business would establish a redemption buy/sell agreement with the assistance of their attorney, accountant, business succession specialists or financial planner. The business would then purchase and own a separate life insurance policy on each owner AND would pay the nondeductible policy premiums on each owner. At the death of one or more owners, the business would receive the generally tax-free income from the death benefit proceeds. The business would use these proceeds to purchase the deceased owner or owners portion of the business interests from their estates.
Advantages of using life insurance
Using a life insurance policy to fund the purchase of this plan is the same as the buy/sell cross purchase plan because it takes the burden off the company to fully fund the buy/sell redemption agreement as well as giving the business the means to buy the business interests from the owner/owners that passed away. Having the amount agreed on before a death of an owner 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 redemption agreement at death
- Life insurance proceeds are usually paid quickly after death, ensuring that the agreement transaction be settled quickly
- Life insurance proceeds are generally income tax free; a C corporation may be subject to the alternative minimum tax (AMT)
Disadvantages of using life insurance
Of course there are also disadvantages to using life insurance to fund the agreement 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 redemption plan.
- The life insurance premiums are not a tax-deductible business expense
- Premium requirements are an ongoing expense
- One or more co-owners may be uninsurable due to age or illness
- 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 accountant’s 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 paying the bills in your company must monitor premium payments carefully. 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.
A better fit may be an executive bonus arrangement to help you attract a higher caliber executive to your business. Of course there are many types of Life Insurance policies for your personal and business insurance needs.