Entity Purchase Buy-Sell Agreement Funded by Life Insurance: A Guide for Single Business Owners
If you are a single business owner, you may have invested a lot of time, money, and effort into building your company. But have you thought about what will happen to your business if you die, retire, or become disabled? Who will take over your ownership interest and how will they pay for it? How will your family be compensated for your hard work and sacrifice? These are some of the questions that a buy-sell agreement can help you answer.
A buy-sell agreement is a legally binding contract between business owners that predetermines the terms of buying out a departing owner’s interest. This agreement is typically funded by life insurance, which ensures that funds are available in the event of an owner’s death, disability, or retirement. In this article, we will explain what an entity purchase buy-sell agreement is and how it works. We will also discuss the benefits of funding a buy-sell agreement with life insurance and how to set up one for your business.
Entity Purchase Buy-Sell Agreement: A Definition and an Example
An entity purchase buy-sell agreement is a type of buy-sell agreement where the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and is the owner and beneficiary of the policies. In an entity purchase buy-sell agreement, the business agrees to buy the ownership interest of any owner who dies, retires, or becomes disabled. The price and terms of the buyout are specified in the agreement.
For example, let’s say you own 50% of a company with two other partners, who each own 25%. You have an entity purchase buy-sell agreement that values the company at $2 million and requires the business to buy out any departing owner’s interest within 90 days of a triggering event. You also have a $1 million life insurance policy on your life that is owned and paid by the business.
If you die unexpectedly, the business will receive $1 million from the life insurance policy. The business will then use that money to buy your 50% share from your estate or heirs for $1 million, as per the agreement. The remaining $1 million will be divided equally between your two partners, who will each own 50% of the company after the buyout. Your family will receive $1 million in cash for your share of the business, without having to deal with any legal or financial hassles.
An entity purchase buy-sell agreement is different from other types of buy-sell agreements, such as cross-purchase and wait-and-see. In a cross-purchase buy-sell agreement, each co-owner buys a life insurance policy on each of the other co-owners. Each co-owner usually pays the annual premiums on the policies they own and are the beneficiaries of the policies. In a cross-purchase buy-sell agreement, each co-owner agrees to buy the ownership interest of any owner who dies, retires, or becomes disabled.
In a wait-and-see (or hybrid) buy-sell agreement, both the business and the co-owners buy life insurance policies on each owner’s life. The business and the co-owners share the premiums and benefits of the policies. In a wait-and-see buy-sell agreement, the parties wait until a triggering event occurs and then decide who will buy the departing owner’s interest.
Benefits of Funding a Buy-Sell Agreement with Life Insurance
Funding a buy-sell agreement with life insurance is a common and effective way to ensure that there is enough money to complete the buyout when an owner dies, retires, or becomes disabled. Life insurance provides liquidity and certainty at the time of a triggering event, which can be beneficial for both the business and the owners’ families. Some of the benefits of using life insurance to fund a buy-sell agreement are:
- Tax-free death benefits: The proceeds from a life insurance policy are generally income tax-free to the beneficiary. This means that the business or the co-owners can use the full amount of the death benefit to pay for the buyout without having to worry about taxes. However, there may be some exceptions or limitations depending on the type and structure of the policy and the entity. For example, a C corporation may be subject to the alternative minimum tax (AMT) on some portion of the death benefit.
- Quick and easy settlement of the buyout: Life insurance proceeds are usually paid quickly after the death of the insured person, ensuring that the buyout can be settled in a timely manner. This can prevent any delays or disputes that could disrupt the business operations or affect the value of the company. It can also provide immediate cash to the deceased owner’s family, who may need it to pay for funeral expenses, debts, taxes, or living costs.
- Fixed and affordable premiums: Life insurance premiums are generally fixed and predictable, making it easier for the business or the co-owners to budget for them. The premiums are also usually affordable compared to the potential cost of the buyout, especially if the owners are young and healthy when they buy the policies. The premiums may vary depending on the type and amount of the policies, the age and health of the insured persons, and other factors.
- Protection of business value and continuity: Life insurance can help protect the value and continuity of the business by providing a smooth and orderly transfer of ownership when an owner dies, retires, or becomes disabled. This can prevent any loss of customers, employees, suppliers, or creditors that could result from a sudden or forced sale of the business or a part of it. It can also preserve the goodwill and reputation of the company in the market.
- Peace of mind for the owners and their families: Life insurance can give peace of mind to the owners and their families by ensuring that they will receive a fair price for their share of the business and that they will not have to deal with any financial or legal problems related to the buyout. It can also reduce any potential conflicts or disagreements among the owners or their heirs regarding the value or disposition of the business.
How to Set Up and Fund an Entity Purchase Buy-Sell Agreement with Life Insurance
Setting up and funding an entity purchase buy-sell agreement with life insurance involves several steps that require careful planning and professional guidance. Some of the steps are:
- Determining the value of the business and each owner’s share: The first step is to determine how much the business is worth and how much each owner’s share is worth. This can be done by using various valuation methods, such as market value, book value, discounted cash flow, or capitalization of earnings. The valuation should be based on objective and realistic criteria and should be updated regularly to reflect any changes in the business or the market. The valuation should also be agreed upon by all the owners and documented in the buy-sell agreement.
- Drafting and signing the buy-sell agreement with the help of legal and financial advisors: The next step is to draft and sign the buy-sell agreement with the help of legal and financial advisors who are experienced in this area. The buy-sell agreement should include all the essential terms and conditions of the buyout, such as the triggering events, the price and terms of payment, the valuation method, the rights and obligations of the parties, and any other relevant clauses. The buy-sell agreement should also be consistent with the owners’ estate planning goals and objectives.
- Choosing the type and amount of life insurance policies that suit the business needs and budget: The third step is to choose the type and amount of life insurance policies that suit the business needs and budget. There are different types of life insurance policies that can be used to fund a buy-sell agreement, such as term life, whole life, universal life, or variable life. Each type has its own advantages and disadvantages depending on factors such as cost, coverage, cash value, flexibility, and tax implications. The amount of life insurance needed should be equal to or greater than the value of each owner’s share in the business. The amount should also be reviewed periodically to ensure that it matches the current value of the business.
- Designating the business as the owner and beneficiary of the policies on each owner’s life: The fourth step is to designate the business as the owner and beneficiary of the policies on each owner’s life. This means that the business will pay for the premiums and will receive the death benefits when an owner dies. The business should also have an insurable interest in each owner’s life, which means that it would suffer a financial loss if an owner dies. The business should also obtain written consent from each owner before buying a policy on their life.
- Reviewing and updating the buy-sell agreement and the policies periodically: The final step is to review and update the buy-sell agreement and the policies periodically to ensure that they reflect any changes in the business or the owners’ circumstances. For example, if the value of the business increases or decreases significantly, if an owner wants to sell or transfer their interest during their lifetime, if an owner gets married or divorced, or if there are any changes in tax laws or regulations that affect the buy-sell agreement or the policies.
Conclusion
An entity purchase buy-sell agreement funded by life insurance is a smart way for single business owners to plan for the future of their company and their family. It can provide a clear and fair mechanism for the buyout of a departing owner’s interest and ensure that there is enough money to complete the transaction. It can also protect the value and continuity of the business and give peace of mind to the owners and their families. If you are interested in setting up an entity purchase buy-sell agreement funded by life insurance for your business, please contact us today. We can help you with the valuation, drafting, and funding of your buy-sell agreement and provide you with expert advice and guidance along the way.
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