Buy-Sell Agreements Funded with Insurance

A buy-sell agreement establishes what happens to a business owner's interest when they die, become disabled, retire, or want to exit. Without such an agreement, ownership may pass to heirs who have no interest in running the business, or surviving owners may lack funds to purchase the departing owner's share. Life insurance provides the liquidity to fund these transitions, ensuring the business continues while the departing owner or their estate receives fair value.

Why Buy-Sell Agreements Matter

When a business owner dies, several problems arise simultaneously:

• The estate needs liquidity to pay estate taxes and support heirs
• Surviving owners need to acquire the deceased's share to maintain control
• The business needs continuity and certainty
• Creditors and employees need assurance the business will survive

Without a buy-sell agreement, the deceased owner's shares pass to heirs through probate. Those heirs become co-owners with the surviving partners. They may demand management roles, disagree on business direction, or want to sell to outside parties. These conflicts can destroy otherwise healthy businesses.

A properly funded buy-sell agreement prevents these scenarios by establishing in advance who will buy the interest, at what price, and where the money will come from.

Cross-Purchase Agreements

In a cross-purchase arrangement, each owner personally buys insurance on the lives of the other owners. When an owner dies, the surviving owners use their policy proceeds to purchase the deceased's interest from the estate.

Structure: In a two-person partnership, Owner A buys a policy on Owner B, and Owner B buys a policy on Owner A. Each owner pays premiums and owns the policy on their partner.

Advantages:

• Surviving owners receive a stepped-up tax basis in the purchased shares
• Proceeds are not subject to corporate creditors
• Simpler for small partnerships

Disadvantages:

• Number of policies required grows rapidly: n(n-1) policies needed for n owners
• Premium costs vary by owner age and health, creating unequal burdens
• Owners must coordinate to ensure adequate coverage is maintained

Policy count examples:

• 2 owners: 2 policies
• 3 owners: 6 policies
• 4 owners: 12 policies
• 5 owners: 20 policies

For partnerships with more than three owners, cross-purchase becomes administratively complex.

Entity Redemption Agreements

In an entity redemption (also called stock redemption), the business itself buys insurance on each owner. When an owner dies, the company uses policy proceeds to purchase the deceased's shares from the estate.

Structure: The company owns policies on all owners, pays all premiums, and is the beneficiary. The company redeems (buys back) the deceased owner's shares.

Advantages:

• Only n policies needed for n owners
• Company handles all premium payments uniformly
• Easier to administer for larger ownership groups

Disadvantages:

• Surviving owners do not receive a stepped-up basis
• Proceeds may be exposed to corporate creditors
• For C corporations, proceeds may affect corporate alternative minimum tax
• Family attribution rules can create tax problems in certain structures

Tax basis example: Owner A has a $200,000 basis in a 50% interest. After the company redeems Owner B's shares, Owner A now owns 100% but their basis remains $200,000. If Owner A later sells the company for $2 million, they have $1.8 million in gain. Under cross-purchase, Owner A's basis would have increased by the purchase price paid, reducing future gain.

Hybrid Agreements

Hybrid (or "wait and see") agreements combine elements of cross-purchase and entity redemption. The agreement gives the company and/or surviving owners options regarding who purchases the deceased's interest.

Common structures:

• Company has first option to redeem; if declined, surviving owners cross-purchase
• Surviving owners have first option; if declined, company redeems
• Proportional split between company redemption and cross-purchase

Hybrid agreements provide flexibility to optimize for tax and business circumstances at the time of death rather than locking in a structure years in advance.

Trusteed cross-purchase: A trustee holds all policies and manages the buy-sell transaction. This reduces administrative complexity while preserving cross-purchase tax benefits. The trust purchases policies on all owners, and when one dies, the trustee distributes proceeds to surviving owners who then purchase from the estate.

Valuation Methods

The buy-sell agreement must specify how the business will be valued. Disputes over valuation are a leading cause of buy-sell failures. Common methods include:

Fixed price: A dollar amount stated in the agreement. Simple but becomes outdated quickly unless updated annually. A $2 million valuation established five years ago may not reflect current $4 million value.

Formula: A calculation based on book value, revenue multiples, or earnings multiples. Examples:

• Book value plus 50%
• 5x average net income for prior three years
• 1x trailing twelve-month revenue

Formulas provide automatic updates but may not capture true market value.

Appraisal: An independent appraiser determines fair market value at the time of the triggering event. Most accurate but introduces delay and potential disputes over appraiser selection.

Agreed value with periodic review: Owners agree on a value annually and document it. If no update occurs within a specified period (e.g., 18 months), the agreement specifies a backup method.

Insurance alignment: Whatever method is chosen, insurance coverage should match the expected payout. If the formula produces a $3 million valuation but only $2 million in insurance exists, a funding gap of $1 million must be financed through other means.

Premium Costs and Funding

Life insurance premiums depend on the coverage amount, policy type, and the age and health of the insured.

Sample annual premiums for term coverage:

Term vs. permanent for buy-sell:

Term insurance is appropriate when:

• Owners plan to sell or exit within a defined period
• Budget constraints are significant
• Coverage needs are expected to decrease over time

Permanent insurance may be appropriate when:

• The business is intended to continue indefinitely
• Cash value accumulation is desired for alternative uses
• Owners want guaranteed coverage regardless of future health changes

Many businesses use a combination: term coverage for the majority of the buy-sell obligation, with smaller permanent policies providing a guaranteed base.

Worked Example: 3 Equal Partners in $6M Business

The Situation: Precision Tool & Die LLC has three equal partners—Michael (age 52), David (age 48), and Jennifer (age 45). Each owns one-third of the company, valued at $6 million. Each partner's interest is worth $2 million.

Agreement Structure Decision:

With three owners, cross-purchase requires 6 policies. Entity redemption requires only 3 policies. The partners choose a hybrid structure: the company will own policies and have first right to redeem, but surviving partners can elect cross-purchase to obtain basis step-up if advantageous.

Insurance Needs:

Each owner needs $2 million in coverage. Using entity-owned policies:

The company pays $5,800 annually to fully fund the buy-sell obligations for death.

Valuation Method Selected:

The partners choose an agreed value approach with annual certification. Each year at their planning meeting, they review financials and agree on a value. If no agreement is reached within 18 months, an independent appraisal is required using a business appraiser certified by the American Society of Appraisers.

Scenario: Michael Dies

Current company value: $6 million Michael's estate is owed: $2 million Insurance proceeds received by company: $2 million

The company redeems Michael's one-third interest for $2 million. David and Jennifer now each own 50% of the company. Michael's estate receives $2 million in cash.

Tax Consequences:

For Michael's estate: Michael's basis in his interest receives a step-up to fair market value at death ($2 million). The estate recognizes minimal gain on the redemption.

For David and Jennifer: Their basis does not increase. Each still has their original basis in what is now a 50% interest rather than 33.3%. If they later sell the company for $6 million, they will have larger capital gains than if cross-purchase had been used.

Alternative scenario: If David and Jennifer elect cross-purchase under the hybrid agreement, they would each pay $1 million to Michael's estate. Their basis would each increase by $1 million, reducing future capital gains.

Disability Provision:

The buy-sell agreement also addresses disability. If a partner is disabled for more than 12 consecutive months, the company has the option to purchase their interest at the agreed value, payable over 5 years with interest at the applicable federal rate.

Annual Review Checklist for Precision Tool & Die:

1. Confirm current business valuation and update agreement
2. Verify insurance coverage matches current valuation
3. Review premium payments are current
4. Confirm beneficiary designations are correct
5. Update if ownership percentages change

Common Buy-Sell Pitfalls

Outdated valuation: An agreement signed when the business was worth $1 million may still show that value when the business is worth $5 million. The estate is dramatically underpaid, or surviving owners lack funds to close the gap.

Insufficient insurance: If coverage lags the business value, surviving owners must finance the difference. A $2 million death benefit against a $3 million obligation leaves $1 million to fund from operations or borrowing.

Unfunded agreements: Some buy-sell agreements exist only on paper with no insurance or savings to fund them. The obligation becomes an unfunded liability.

Mismatched ownership: If the agreement calls for cross-purchase but the company owns the policies, or vice versa, the proceeds may not reach the right parties.

Divorce and creditor issues: Without proper provisions, a divorcing spouse or owner's creditors may claim rights to the business interest. The agreement should address these scenarios.

Buy-Sell Agreement Checklist

Agreement Structure

• Determine whether cross-purchase, entity redemption, or hybrid is appropriate
• Specify triggering events (death, disability, retirement, termination, divorce, bankruptcy)
• Define terms for each triggering event (mandatory vs. optional purchase)
• Address what happens if insurance proceeds are insufficient
• Include provisions for voluntary transfers and right of first refusal
• Specify dispute resolution procedures

Valuation

• Select valuation method (fixed, formula, appraisal, or agreed value)
• If fixed or agreed value, establish annual review requirement
• Document current valuation and methodology
• Ensure valuation is defensible for estate tax purposes
• Align insurance coverage with expected valuation

Insurance Funding

• Calculate coverage needed for each owner's interest
• Determine policy owner and beneficiary consistent with agreement type
• Obtain quotes from multiple carriers
• Select appropriate policy type (term or permanent)
• Verify all owners are insurable; address uninsurable owners
• Document premium payment responsibility

Administration

• Store original agreement with corporate records
• Provide copies to all owners and their estate planning attorneys
• Track policy ownership and beneficiary designations
• Calendar annual valuation review
• Update coverage when valuation changes materially
• Review agreement when ownership changes
• Coordinate with each owner's personal estate plan