What is a buy-sell agreement?
When businesses have multiple partners and one passes away, it can be difficult to sort out the remaining shares. Businesses can set up a buy-sell agreement that says the proceeds of a life insurance policy will buy out the deceased partner’s shares and sell them back to the business. Buy-sell agreements can be an important tool for business owners’ estate planning to avoid personal and business conflicts.
When a business partner dies, not only is it personally devastating, but it may also leave questions about how the business will be handled or how their shares will be divided. Small business owners can utilize insurance to ease this process and create a continuity plan for the future success of the business. For example, estate equalizations through life insurance let entrepreneurs pass their business onto the next generation efficiently, or key person insurance can mitigate expenses or losses when trying to replace an employee or partner that was vital to the business.
Buy-sell agreements are legal contracts between business partners or shareholders to limit who can own shares of their private corporation or partnership if an owner dies, becomes critically ill, or wants to sell their stake in the business. Life insurance, critical illness insurance, and disability insurance are vital components of buy-sell agreements as their benefits create available funds for the agreement transactions.
In this article, we discuss the topic of business-owned life insurance and buy-sell agreements. Specifically, we detail how buy-sell contracts work, who the beneficiaries are, and when such an agreement becomes legally binding.
What is business-owned life insurance?
Business-owned life insurance, also known as corporate-owned life insurance (COLI), allows the business to pay the premiums for the policy. Generally speaking, the business paying for the policy should also be a beneficiary of the COLI (instead of the deceased’s family) so the premiums do not become a taxable benefit. The business can thereby collect proceeds upon the death of the person covered under the insurance policy.
There are numerous benefits to business-owned life insurance. It’s frequently used for funding business agreements or structures such as buy-sell agreements or insurance tracking shares. COLI may also be used to insure key persons in the business. This is vital as a key person’s death may require the business to hire someone in their place for a significantly higher salary. If the policy is a whole life policy, a company may also use it as collateral on a loan.
What is a buy-sell agreement?
Buy-sell agreements are contracts between shareholders or owners of a business. It details how the business’s shares may be bought, sold, or redeemed upon certain pre-specified triggering events. These agreements commonly stipulate that shares must be sold to the organization’s remaining shareholders if one person passes away or wants to relinquish their stake. This way, remaining shareholders control who can have a stake in the business. It ultimately prevents unwanted partners or estate beneficiaries from owning the company and having a say in how the corporation is run.
For example, suppose RestaurantFranchiseCo. has three owners: Abby, Jason, and Sam. The three owners have equal shares in RestaurantFranchiseCo. If Sam suddenly passes away, her ownership in the business would become part of her estate. This leaves the possibility of an estate beneficiary trying to barge their way into RestaurantFranchiseCo., thinking they can change the business since they now own Sam’s portion of the company. But, a buy-sell agreement prevents this scenario by forcing Sam’s shares to be sold to Abby and Jason or RestaurantFranchiseCo upon Sam’s death.
This may also work if, instead of death, Sam faced a severe illness. In this case, Sam may wish to relinquish her ownership. The buy-sell agreement would then stipulate how she could go about monetizing her shares by selling them back to the company or other shareholders.
A buy-sell agreement also creates liquidity for the shares of a private corporation, which are usually illiquid. In the case of death, the agreement often converts the late shareholder’s shares into cash. This allows the estate administrator to distribute the assets more efficiently.
Ultimately, the agreement makes the death of a shareholder less of a burden on the business and its surviving partners. The agreement prevents many future legal disputes by detailing what should happen upon a partner’s death, illness, or disability; how the business is valued; and how the corporation or other partners would fund the buyout.
Key uses of a buy-sell agreement are:
- Ensuring the financial health or viability of the business and the departing shareholder
- Seamless transfer of business interests amongst shareholders
- Minimizing potential disputes amongst shareholders
- Creating liquidity for illiquid shares
- Reinforcing business stability to key stakeholders including creditors, suppliers, customers, employees
What should be included in a buy-sell agreement?
Buy-sell agreements contain provisions for triggering events and business valuations:
- Triggering events: A specific definition of a triggering event is usually included in such agreements. Death as a triggering event may not require much explanation. However, if a critical illness or disability is a triggering event, then clear and verifiable definitions of such events should be included. It should define what constitutes a critical illness or disability and what may result from it. The definition of such triggers should be in-sync with the definition included in the insurance document. For example, a triggering event clause may state that other shareholders or the corporation can purchase that shareholder’s stake after three months of the shareholder’s incapacitation. It could also dictate that a shareholder must sell their ownership if they’re no longer able to contribute to the business due to illness or disability. Triggering clauses can include any of the following:
- Passing away of the shareholder
- Long-term disability
- Diagnosis of a critical illness
- Retirement from business
- Marital breakdown
- Resignation or termination of the shareholder as an employee
- Bankruptcy declaration
- Intention to exit
- Business valuation: A clear dollar value or a methodology to establish the valuation of the business that can be independently verified must be laid out. This may relate to a specific formula, a pre-determined amount, or facilitate an independent valuation. The valuation determines the price at which the owner referred to in the triggering event can sell their ownership. Companies that agree to a pre-determined amount often reassess this amount annually, as a business’s worth can easily change.
- Funding strategy The buy-sell agreement must contemplate where the corporation or other partners will get the capital to buy out the deceased person’s shares. This is usually referred to as the funding strategy. Buy-sell agreements can be funded through proceeds from life insurance, critical illness, or disability insurance policies. The beneficiary of the policy may be the corporation or the business partners. The beneficiary would then use the insurance payout to buy out or settle the shares of the deceased or sick shareholder.
An insurance policy isn’t mandatory for a buy-sell agreement. But it allows partners or the corporation to purchase the shares without using their personal funds. Additionally, suppose the business is valued at a high amount. In that case, the surviving shareholders or the corporation might not have the cash on hand to purchase the shares without taking a loan or impeding cash flow. The insurance payout is meant to provide enough money to settle the shares if an owner dies or wants to cash out their ownership.
Looking back to RestaurantFranchiseCo., Sam may have life insurance, critical illness, and/or disability insurance, with Abby and Jason or RestuarantFranchiseCo. as the beneficiaries. In the situation of Sam’s death, Abby and Jason or the corporation could use the death benefit to buy out any of Sam’s shares. In the case of illness or disability, the business could forward the policy’s payout to Sam in exchange for her ownership.
Lastly, a funding strategy should consider what happens if there is a deficit or surplus between the buyout amount and the life insurance payout. There may also be other ways to fund the buyout aside from life insurance, such as a line of credit or sinking fund.
How does a buy and sell agreement work?
Buy and sell agreements are legal agreements and require the help of a lawyer. It’s often part of a shareholder’s agreement. A lawyer’s services ensure an effective buy-sell agreement that executes the way everyone intends. Ambiguities or complexities in the business may result in legal disputes between business partners or the late owner’s beneficiaries on specific responsibilities or the valuations of the shares. These legal disputes would likely cost more than the price of a properly drafted buy-sell agreement.
Beyond the legal nitty-gritty, buy-sell agreements that leverage life insurance follow three steps:
- Business valuation: the partners or shareholders use a formula or independent evaluator to decide how much the business is worth.
- Insurance purchase: Each owner gets a policy equal to the value of their stake in the company. They may further purchase a guaranteed insurability rider. This rider allows them to increase the value of the insurance policy to match the appreciation of the business’ value without going through the underwriting process again.
- Triggering event: If a business owner passes away or any other triggering event happens, the insurance payout is also triggered. The surviving owners then use the insurance payout to buy out the other shareholder’s stake.
Who is the beneficiary of a buy-sell agreement?
There can be several beneficiaries in a buy-sell agreement. First, there are the beneficiaries of the life insurance and/or critical illness/disability insurance policy. These are either the surviving partners of the business or the corporation. When the surviving partners are the beneficiaries, they ultimately receive the payout and buy out the shares, meaning they’ll each own more shares. If the corporation receives the death benefit and makes the buyout, then the shares are settled (effectively erased). However, this means the remaining shares are now worth more because there are fewer outstanding shares.
Many factors may determine whether the insurance beneficiaries should be the shareholders or the corporation. For example, if the business has many owners, it may be easier to have the corporation as the beneficiary instead of the partners of the firm. This choice may also change who has to pay for the policies.
Beneficiaries in a buy-sell agreement may also refer to the estate beneficiaries of the deceased owner. These beneficiaries become the final recipient of the insurance payout. After the partner or corporation receives the death benefit, they then purchase the shares from the late owner’s estate. The estate administrator eventually distributes this payout to the estate beneficiaries, pending estate taxes, and creditors.
Things to keep in mind when setting up a buy-sell agreement.
- Have the agreement or contract prepared by a licensed lawyer. This is key to ensure the buy-sell agreement is effective and works as intended in the unfortunate event of a business partner’s death
- Include a Guaranteed Insurability Rider. This will allow you to increase the value of the insurance policy to match the increased value of your business without having to go through the application process again
Are buy-sell agreements legally binding?
This article won’t go into the technical details of contract law. But buy-sell agreements are generally legally binding as long as the parties signed the agreement while they were of sound mind. There are numerous situations where this may be untrue. It’s best to speak with a legal professional if you want to understand more.
Ultimately, if you’ve properly drafted a buy-sell agreement with an experienced corporate lawyer and signed it at their office, the agreement is most likely legally binding.
Buy-sell agreements are an essential facet of small businesses. They allow shareholders to remain in control of the corporation when an unfortunate circumstance requires an owner to exit the company. This commonly occurs with death, illness, or a disability.
Life insurance and critical illness and disability insurance are crucial to a well-structured buy-sell agreement. Speak to one of PolicyAdvisor’s insurance experts to learn more about the policies you need for your business’s buy-sell contract. Schedule a call today!
Business-owned insurance products can vary depending on the needs of your business. An independent broker like PolicyAdvisor can help you sort through your options, find you a quote, and advise if your insurance needs are growing beyond that of a personal broker. We can also collaborate with tax lawyers to ensure that your business will be passed down in a tax-efficient manner. Reach out to our experienced advisors below and they can get you started down the right path for covering yourself and the business you’ve built.
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- Buy-sell agreements are contracts between shareholders or owners of a business that detail how the business's shares may be bought, sold, or redeemed
- Life insurance is commonly used to fund the purchase of partner shares when a partner passes away
- Setting up buy-sell agreements allows a business to avoid future conflict during a business’s transition period after a partner passes away
- The full cycle of the agreement usually includes a business valuation, insurance purchase, and a triggering event (a partner passing away)