There are several ways to fund a buy-sell agreement, including the creation of a sinking fund (holding back business profits ― creating an after-tax cash reserve ― to cover the cost of the buy-sell), agreeing to an installment sale (using existing company cash flow to make the installment payments), or borrowing (taking a loan to fund the buy-sell). While these approaches are valid options, many business owners choose to fund their buy-sell agreement with life insurance.
There are a number of reasons why funding a buy-sell agreement with life insurance may make sense to your company.
- First, a life insurance policy’s death benefit creates a lump sum of cash that could be used to fund the purchase obligation in the buy-sell agreement when triggered by the death of a company owner. In many instances, the company, or surviving owner, does not have cash readily available to fund the purchase, even having created a sinking fund.
- Second, after a claim is made, the insurance issuer usually provides the death benefit in a timely manner, allowing the buyer to have a ready source of funds to complete the purchase and continue the business with fewer interruptions.
- Third, depending on the type of life insurance policy you purchase, the premiums remain level, allowing you to fund the agreement with a predictable expense.
- Finally, since life insurance premiums are paid with after-tax dollars, the proceeds of the life insurance policy are, generally speaking, received income tax free.
- There are two types of life insurance for you to consider using to fund your buy sell agreement – permanent and term. Each has its own benefits depending on your needs and objectives.
Term insurance provides temporary coverage for a specific period of time. It only provides death benefit protection; there is no cash value component. Consequently, the initial premiums for term insurance may be lower than a comparable coverage amount of permanent coverage. (Related: 4 times when term may be the answer)
Term insurance can be a good option for companies with limited cash flow. The traditionally lower premiums offered by term insurance can be especially advantageous to any company who needs coverage but may have limited funds, including those just starting out or others operating on a tight budget. Term insurance can also be a cost effective option for companies who have a specific time frame in mind, such as the intention to sell the company after a number of years, or to coordinate the policy’s term with the planned retirement of a principal.
Many term insurance policies also include a provision to convert to a permanent policy with no additional need for medical underwriting. This provision can help provide start-ups with more flexibility, providing important coverage today with the opportunity to build cash value (when converted to a whole life insurance policy) once the company grows and increased cash flow is available.
Permanent insurance offers lifetime protection. This means that the identified beneficiaries, as long as premiums are paid, will receive a death benefit no matter how long the insured lives. (Related: Understanding different types of permanent insurance)
One type of permanent insurance – whole life insurance – is lifetime coverage that also accumulates a guaranteed cash value. In addition to the death benefit, this guaranteed cash value can provide living benefits.
One such benefit could be that the cash value of the policy can be used to partially fund the buy-sell agreement for a trigger other than death. Disability, divorce, retirement, personal bankruptcy, involuntary termination or disqualification (loss of license to practice) are all topics that should be addressed in a well drafted buy-sell agreement. The cash value of the policy can be used, in the form of a loan or withdrawal, to fund some, or all, of the agreement when needed. 1
Depending on the structure of your buy-sell agreement, the business may be able to carry the policy cash value on the books as a company asset (talk to your accountant). This asset can be accessed (in the form of a loan) for other business uses.
Upon retirement of an owner, the ownership of a whole life policy may be transferred to the retiring individual (the insured). The insured can then use the policy, and its guaranteed cash value, as they wish. They can name their own beneficiary for the death benefit and/or use the cash value to supplement their retirement income. There may be some income tax consequences to this transfer, so make sure to consult your tax advisor.
Consider Your Choices
You’ve built your business by making smart decisions. Choosing how best to fund a buy-sell agreement presents another opportunity to make a smart choice, one based on the needs of yourself, your partner and your business. Find what works best for you and offers the best options for the future.
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1Access to cash values through borrowing or partial surrenders can reduce the policy’s cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.