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Under a buy-sell agreement, when an owner dies, becomes disabled, or gives up ownership for some reason, the company or remaining owners may have to purchase the interest at stake. It is critical to fund the buyout. Without a practical funding plan, a company or its owners may have to pay out liquid assets in a lump sum at an inopportune time or declare bankruptcy. Without sufficient funding, a buyout provision could prove to have little or no value.
Buyouts can be funded in several ways. The simplest way is to pay cash to the departing owner or the owner’s estate. This, however, can be problematic. If any owner’s stake is very valuable, it would require the company or all owners to maintain large cash reserves that could otherwise be invested more productively or spent. The company or remaining owners can use a loan to fund the buyback. A lender might hesitate to make the loan, however, if the deceased or departing owner was a key employee whose effort and talent were necessary for the success of the organization. The lender will require collateral, and the value of the business as a going concern may now be lower than it was before the owner’s departure.
Perhaps the most practical means of funding a buyout is with insurance. A good life insurance policy or disability insurance policy can supply sufficient funds to purchase the shares at stake and allow the organization to maintain sufficient liquidity under the newly constituted ownership.
Buyouts can be structured so that the company has the option to purchase the interest. If the company declines the option, one or more of the remaining owners can buy it. Insurance policies can be structured to accommodate these arrangements. Under the “entity purchase” alternative, the organization purchases life insurance policies with respect to each owner, pays the premiums, and is the beneficiary. Under the “cross purchase” alternative, each owner purchases life insurance with respect to every other owner. The owners pay the premiums and are the beneficiaries. In most instances, it is less expensive and easier to use the entity purchase method. Before purchasing life insurance, one should consult with a knowledgeable insurance agent who can explain the various types of products available and their respective costs and benefits.
The face value of the policies must be sufficient to purchase the value of the ownership interests. As the company increases in value, the policyholders may need to purchase additional coverage to cover the cost of a buyback. This has an additional cost, and life insurance becomes more expensive as the insured becomes older.
Many life insurance policies have a cash surrender value. Thus, if an uninsured event (such as divorce or personal bankruptcy) occurs, the policyholder can cash in the policy during the lifetime of the insured and use the money to fund all or a portion of the buyout. If the proceeds are insufficient to buy back the interest, the buyers may use the cash as a down payment and agree to pay the balance in installments under the terms of a promissory note.
Owners should understand the tax consequences of life insurance. While parties who purchase life insurance do not get a tax deduction for the premiums, generally, the proceeds are not subject to income tax. If the proceeds are paid to the company (not the estate of the deceased owner) they avoid estate tax so long as the insured owner did not maintain “incidents of ownership.” Essentially, the insured owner should not have the right to purchase the policy, make the premium payments, or control the policy terms or distribution of proceeds.
Disability insurance can fund the buyout of a disabled owner. The insurance company will determine whether the person is totally disabled. If it decides that the person is not disabled, the owner may still retire under the terms of the buy-sell agreement. The owners can cash in a life insurance policy for its surrender value to fund the buyout.
Disclaimer: This column is not legal advice.