Protecting Your Business by Using Life Insurance to Fund Buy/Sell Arrangements

In meeting with small business owners, conversations inevitably include plans for the succession of the business should they or one of their business partners die unexpectedly, become disabled or retire. 

Unfortunately, many small business owners don’t have a formal transition plan if the owner dies unexpectedly, sells the business or retires. If any one of these events occurs, a lack of effective succession planning could prove to be a fatal blow to a business. One efficient business planning tactic is to create a buy/sell arrangement with a successor and fund the transition by using a permanent life insurance policy.

Utilizing permanent insurance to protect the parties to the agreement can be a cost efficient strategy to help fund the transfer of the business. The insurance proceeds would be used by the surviving family members or remaining business owners to buy the company interests of a deceased owner at an established price. This allows for the surviving family to receive fair value of the business and prevents the remaining business owners from trying to scrape up additional funds to buy out the outstanding portion of the company.

First, let’s define a typical buy/sell arrangement. A properly constructed buy/sell arrangement would provide the family of the deceased business owner or the surviving business partners the (most likely) tax free death benefit to transfer the business. The arrangement would call for the business owner and the succeeding owner to enter into a buy-sell arrangement in which the succeeding owner agrees to buy the business in the event of the owner’s death, disability, or retirement. The arrangement could be funded by a permanent life insurance policy on the owner’s life. The succeeding owner would own the policy on the insured owner’s life and the company would pay a bonus to the succeeding employee to cover the cost of the insurance premium. The employee would then pay the premium to the insurance company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

The benefits to both parties of this arrangement are significant:

1. The life insurance proceeds are likely to be received income tax free.
2. The succeeding owner will likely receive a step-up in cost basis for the purchase of the business interest (i.e., should the new owner sell that portion of the business that was purchased through this arrangement, the new owner would pay capital gains based on the difference between the sale price and the new cost of the business, thus possibly reducing the amount of capital gains tax).
3. The company might receive a tax deduction for the bonus paid the insured employee.
4. Succeeding owner could accumulate sufficient cash value from the insurance to begin a structured buy-out plan while the original owner is still alive.
5. Corporate Alternative Minimum Tax and accumulated earnings tax might not be impacted by the proceeds of the policy.
6. The overall value of the business would not be impacted by the policy values.

There are, however, important things to consider for the employee who owns the policy. For example, the value of the life insurance policy would be includable in his/her estate should he/she pre-decease the business owner. The bonus received from the business to pay the premium must be recognized as taxable income to the employee. Any withdrawals against the cash value by the employee to initiate a buy-out of the business would reduce the death benefit of the policy, thereby reducing the amount available to complete the transfer upon the owner’s death.

A formal business succession plan is critical to maintaining the financial and operational viability of any business, but especially a small business. Considering the negative impact a poorly planned business transition strategy, the creation of a properly funded buy/sell arrangement should be delivered as soon as possible.

For questions you may have about this article or buy/sell arrangements, please e-mail me.