How funding with life insurance works

​

When using life insurance with a buy-sell agreement, either the company or the individual co-owners buy life insurance policies on the lives of each co-owner (but not on themselves). If you were to die, the policy owners (the company or co-owners) receive the death benefits from the policies on your life. That money is paid to your surviving family members as payment for your interest in the business. If all goes well, your family gets a sum of cash they can use to help sustain them after your death, and the company has ensured its continuity.

 

Advantages of using life insurance

​

• Life insurance creates a lump sum of cash to fund the buy-sell agreement at death

• Life insurance proceeds are usually paid quickly after your 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

• If the co-owners' ages vary widely, younger co-owners will have to pay higher premiums on the lives of the older co-owners

 

How to set up different types of buy-sell agreements

 

In an entity purchase buy-sell agreement, 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 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. If your company has a large number of co-owners, multiple policies must be purchased by each co-owner.

 

The buy-sell agreement should be fully funded

​

The amount of insurance coverage on your life should equal the value of your ownership interest. Then, when you die, there will be enough cash from the policy proceeds to pay your family or estate in full for your share of the business. But if all that is affordable is insurance coverage for a portion of your interest, you might want to go ahead and fund that amount. Later, the company may be able to increase the amount of insurance or use additional funding methods. In the meantime, the agreement should specify how your family or estate will be paid.

 

The value of the business could change over time

What if the insurance proceeds turn out to be less than the value of your business interest, due to growth in the business? Your surviving family members might end up getting less than full value for your business interest. Your buy-sell agreement should specify how the valuation difference will be handled.

 

Conversely, the insurance proceeds might be greater than the value of your business interest when you die. Your buy-sell agreement should address this potential situation upfront and specify whether the excess funds will belong to the business, the surviving co-owners, or your family or estate.

 

Should group life insurance be used?

​

Using a company's group life insurance plan to fund a buy-sell agreement is not recommended. Normally, group life insurance premiums are tax deductible to the company. But premiums are no longer deductible if the business is the beneficiary.