Funding a Buy Sell Agreement with Life Insurance

Joseph Meyer
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What is a Buy-Sell Agreement and Why Do You Need One?

If you own a business, you should consider signing a buy-sell agreement.

The primary reason for this is that the owners of the business want to ensure that their business will continue should one of them die. While business owners can’t guarantee that their business will continue to grow, they can guarantee continuity with a buy-sell agreement.

Types of Buy-Sell Agreements That You Can Implement

Life insurance is an investment vehicle that can be used to fund all types of buy-sell agreements. The decision to use life insurance as part of your buy-sell agreement depends on your objectives, company needs and insurance needs. For example, say a partnership is seeking to replace a retiring partner with capital rather than putting their financial future in the hands of a new partner. If the value of the business entity remains stable or appreciates, a cash value life insurance can be a great solution to replace the retiring and deceased partner, while maintaining the entity. By increasing the capital coverage, the existing partners can maintain their percentage interest in the entity. A properly structured cash value life insurance is a seamless solution to complement existing business arrangements.

Why is Life Insurance the Best Way to Fund a Buy-Sell Agreement?

An employee buy-sell agreement is a way to provide a financial safety net for partners, families and employees upon the death of one of the business owners. With an employee buy-sell agreement, partners can agree upon a price at which the entire business can be bought out by the remaining partners, or even by employees. This can be particularly useful for small family-owned businesses where the remaining partners can purchase a deceased partner’s share of the company.

Although it may be possible for a small business to obtain financing to fund such an agreement, this is usually not an option. Banks are usually reluctant to lend small businesses (especially family-owned ones) substantial money due to the risk of the business going out of business. And since the agreement is to buy out the remaining partner(s) in the event of death, there is no collateral to show that the loan would be paid back.

For this reason, many business owners decide to take out a life insurance policy on one of the business owners who then agrees to use the proceeds from the policy to fund the buy-sell agreement. The partners are still financially protected (as the death benefit is a tax-free benefit of the policy), and the partner who purchases the policy (through a policy loan) pledges to use the proceeds of the policy to purchase the deceased partner’s shares of the company.