What to Know About Funding a Buy-Sell Agreement

When you’re starting or growing a business with a partner, composing a buy-sell agreement isn’t as much fun as your next big sales pitch, but it should be a key priority. It’s an agreement that protects you and the business if something should happen to you or your partner. 

“Unless you have a buy-sell agreement, you could find yourself sharing the reins with a former partner’s spouse, children or someone else who knows little about your business and isn’t as invested in its success as you are,” says John Muth, director of advanced planning at Northwestern Mutual. “Yet that scenario often plays out either because business partners never created or funded an agreement in the first place, or the one they have is outdated.” 

A buy-sell agreement is basically an exit strategy for you and your business partners. It can help protect you and your family because it sets ground rules for how ownership shares should be handled should you or one of your partners leave the business.  

Here are four things you should consider when setting up or reviewing a buy-sell agreement.  

1. KNOW WHAT YOUR BUSINESS IS WORTH

   A buy-sell agreement establishes a fair value for your ownership shares using either a valuation formula, such as a multiple of earnings or sales, or by setting a value outright.

   “Having a valuation for your business can help avoid any potential conflicts down the road should a former business partner or their beneficiary demand more for their ownership shares than you believe they’re worth,” says Muth. “And updating your valuation periodically also provides a way to track the growth in your business’s value for your own personal financial and estate planning purposes.”
    

2. DECIDE ON A STRUCTURE

   Buy-sell agreements take many forms, but most fall into one of two structures – an entity-redemption plan or a cross-purchase plan. With an entity-redemption plan, the business entity itself is obligated to buy out or redeem the ownership interests of a departing owner. With a cross-purchase plan, each surviving owner agrees to buy a specific percentage of the departing owner’s interest.
    

3. BE SURE TO FUND IT

   If you ever need to act on your buy-sell agreement, money will change hands. That means you need a plan for where that money will come from. Sources could include cash, a sinking fund, installment payments or taking a loan. However, many business partners find that life insurance is the most cost- and tax-efficient way to have money readily available if an owner departs the business.

   “With an entity-redemption agreement, the business purchases separate life insurance contracts on the lives of each owner, pays the premiums, and is the owner and beneficiary of the contract. When an owner passes away, the business uses the income-tax-free death benefit to purchase the deceased owner’s shares,” explains Muth. “With a cross-purchase buy-sell, each owner purchases a policy on the other owner(s). When one of the owner’s dies, the surviving owner(s) use the death benefit to purchase the deceased owner’s shares.”
    

4. LIFE INSURANCE FUNDING OPTIONS

   You can fund a buy-sell agreement with term or permanent life insurance. Each has its own benefits, says Muth.

   Term insurance provides temporary coverage for a specific window of time and has no cash value component. However, the initial premiums may be lower than they’d be for a comparable amount of permanent life coverage.

   “This can make term insurance an attractive option if your business has limited cash flow, specific budgetary constraints, or if you need coverage only for known amount of time, say, because you plan to sell the business or a partner plans to retire in the not-so-distant future,” says Muth.

   Permanent life insurance, on the other hand, offers protection for life. In addition to the death benefit it provides, permanent life also accumulates guaranteed cash value. That money can be accessed to fund all or a portion of a buy-sell agreement, should you or one of your partners leave for a reason other than death.

   “When you retire, you may be able to have the ownership of the policy on your life transferred and take the policy with you. That would enable you to name your own beneficiary for the death benefit and use any accumulated cash value to supplement your retirement income, fund a new business, or do whatever you want,” Muth says.

   He added that there may be tax implications with the transfer of your policy, so be sure to consult your tax advisor first. 

A well-crafted, properly funded buy-sell agreement can offer you peace of mind that your business and family would be protected if something happened to one of your partners. If you think a buy-sell agreement could benefit you and your business, consult your financial professional to learn more about how to move forward and to coordinate with your attorney to draft the buy-sell agreement. 

This publication is not intended as legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.