If you already have a buy/sell agreement, or are thinking about putting one in place, consider how the purchase of shares after a shareholder’s death will be funded. Will the surviving share-holder(s) have to obtain a bank loan to finance the purchase? What if the person has trouble obtaining a loan? Alternatively, should the company itself buy back the shares from your estate, using excess cash? What if the company is not in a financial position to do this, and is also unable to borrow any additional money from its banker? Are there other sources of funds (e.g. selling off part of the business)?
Of all the funding alternatives, life insurance usually makes the most sense. In fact, there can be significant income tax advantages in utilizing corporate-owned life insurance to provide the funding for buying back a deceased’s shareholder’s stake in the company. Talk to an experienced life insurance agent to explore the possibilities.
Here is a summary of the common methods of insurance funding options:
Corporate-Owned Insurance
The corporation insures the lives of the shareholders and receives the insurance proceeds on their deaths. These funds are then used by the corporation to buy the deceased’s shares, either from the estate of the deceased shareholder or from the surviving spouse.
Criss-Cross Insurance
With this type of policy, each shareholder of a corporation acquires a life insurance policy on each other’s life. When one shareholder dies, the surviving shareholders receive the tax-free proceeds of the policy, then used to purchase the shares of the deceased from his or her beneficiaries or estate. The disadvantage of this type of structure is that the insurance cost on each shareholder can vary considerably depending on their health and age.
Split-Dollar Insurance
This is a hybrid version of corporate and criss-cross insurance. In this example, each shareholder purchases a whole-life type of policy on the other shareholder. The cash value of the policy is assigned to the company, which the company receives when a shareholder dies. The surviving share-holders receive the face value of the policy minus the cash value. These funds are then used to purchase the shares. Most, if not all of the premiums are paid for by the company.
Key Person Insurance
In addition to buy/sell insurance, you should also consider disability and key person insurance. Although key person insurance is not directly related to a buy/sell agreement, you should be aware of this insurance option. Basically, it means that the key person or persons in the company are insured, usually the general manager or a managing partner. The purpose of the coverage is to provide funding for the company to weather the transition of a person who is integral to the operation of the business. This could include paying for temporary consulting expertise or hiring a replacement with extensive experience-anything to ensure that the company survives the loss of the key person.
