‘Til Death Do Us Part

Alex and Brad, both in their mid-40s, had just celebrated the 10th anniversary of their market consulting business. The next morning, Brad suffered a heart attack and died. Alex suddenly lost his long-time business associate.

What's more, after the estate was settled, he found himself with a new co-owner: Brad's wife.

The result was chaos. Brad's wife had little interest or experience in running the firm. She needed cash for living expenses and asked Alex to buy out her interest in the business.

Since most of his assets were tied up in the business, Alex was short of cash.

Unfortunately, Alex and Brad's wife were left with little choice but to sell the company on short notice for just a fraction of what they had hoped for.

How could this fictional disaster have been avoided?

A buy-sell agreement and proper funding could have saved their business while providing needed income for Brad's family after his death. Buy-sell agreements clarify how ownership will change hands and how the transfer will be paid for in the case of a co-owner's death, disability or retirement.

Typically, the agreement provides for the purchase of the outgoing shareholder's stock by the surviving shareholders or the company itself.

A buy-sell agreement and its proper funding may achieve several goals:

– Avoid liquidation of the business

– Facilitate an orderly continuation of the business

– Replace lost business income for a deceased owner's heirs

– Set a purchase price that can fix the estate tax value of the decedent's stock

– Provide evidence to customers and creditors of the firm's stability

How to Fund a Buy-Sell

Drafting a buy-sell agreement is only the first step, because unless the purchaser can afford to buy the deceased owner's shares, it's impractical.

Life insurance is often used as the source of cash. When a business owner dies, the policy proceeds are used to buy the shares from the deceased owner's estate at a set price.

Insurance is beneficial even if no one dies. Newer products structured for businesses have a return of premium in the first ten years, for example, unlike traditional policies. At $5,000 a year, the owner of the policy would have $25,000 (worst case) in year five, $50,000 in year 10.

The cash spent on life insurance stays in the business or on the personal balance sheet, and because it is available, can be used as bank collateral, or simply for peace of mind.

Types of Buy-Sell

There are two basic types of buy-sell arrangements: the cross-purchase agreement and the stock redemption agreement. Life insurance can be used to fund both.

Cross-purchase agreement: Good for businesses with few owners

In Alex and Brad's situation, each of them buys (and is the owner and beneficiary of) a life insurance policy on the other.

Upon Brad's death, Alex receives the policy's death benefit, which he uses to purchase Brad's shares from Brad's estate. In turn, that cash payment gives Brad's family the needed income to offset the loss of Brad's earnings.

Cross-purchase plans have several advantages. For example, the surviving shareholder gets a "step up" in the income tax basis for the stock bought from the deceased's estate. This could reduce income taxes if the surviving shareholder later sells the stock.

The insurance proceeds from this arrangement are not subject to the corporate alternative minimum tax (AMT), nor to the claims of corporate creditors, but these plans can be hard to administer if there are many owners.

Stock redemption agreement: Good for multiple owners

Here, the company buys and owns insurance policies on the lives of Alex and Brad. When Brad dies, the corporation buys his stock with the insurance proceeds.

Stock redemption plans may make sense when there are multiple owners of the corporation, there are large differences in age and ownership levels among the owners, or the corporation is in a lower tax bracket than the owners.

Two potential drawbacks to these plans:

– Death proceeds received by the corporation may be subject to the corporate AMT.

– Surviving shareholders do not get the benefit of an increase in the income tax basis of their shares when the corporation redeems the stock.

Minority vs. Majority Shareholders

Often, in an effort to make things fair, business owners structure a life insurance funded buy-sell agreement so that each owner is treated alike, but that may result in a windfall if the majority owner dies before the minority owner.

In Brad and Alex's case, Brad owns 70 percent of the company, which is valued at $1 million.

Under their agreement, identical terms were set for the life insurance and the subsequent buyout.

When Brad died, Alex collected the $700,000 of insurance proceeds and pays that sum to Brad's family for the controlling interest in the company.

Alex could also buy back his own insurance coverage of $300,000 for full value, which means he now has 100 percent interest in a million dollar company, as well as a $300,000 policy.

Brad's family loses control of the firm, but receives $700,000 in cash and the proceeds from the sale of the insurance on Alex's life.

Buy-sell agreements can help protect your business and your family. Seek the guidance of a professional financial adviser who can identify the various issues and considerations that will help determine what type of buy-sell agreement makes the most sense for you.

Erik Gruber is a registered representative of Lincoln Financial Advisors Corp., a broker/dealer and member, SIPC. He is a member of Sagemark Consulting, Private Wealth Services Group. Erik and his team specialize in the development, implementation and sustainability of family wealth transition plans. He can be reached at (231) 668-4147 or Erik@ErikGruber.com.