woman and man funding a buy sell agreement

When exploring how to sell your business to a new owner you have probably come across the concept of a Buy Sell Agreement.  Or perhaps you want to preserve the value of a business you’ve poured your heart into to protect your family and loved ones should something happen to you. If so, you may be wondering “how in the world can someone actually afford to buy my business on short notice?” Don’t worry, there are various options that can make it easier for you to purchase a partner’s ownership in your business (and vice versa). In this article we’ll cover the primary ways to fund a Buy Sell Agreement.

Key Points
  1. Buy sell agreements can be funded in a number of ways, including life and disability insurance.
  2. A cross-purchase plan involves the owners purchasing insurance policies on the other owners, whereas an entity-purchase plan has the business purchase the insurance policies.
  3. While disability is a more likely scenario, funding a buy-sell with disability can be very expensive, and it may not be possible depending on the owners’ health.
  4. An installment sale can be used when you can’t get insurance, but it is generally a riskier option.

Recap: What is a buy-sell agreement?

A buy-sell agreement is a legally binding agreement between two or more individuals, which outlines who will purchase ownership of the business in various scenarios, like retirement or disability. You can read more about buy-sell agreements here.

Funding a Buy-Sell Agreement With Life Insurance

Life insurance, while morbid, can be a powerful tool in funding a buy-sell agreement. There are two main ways to structure a buy-sell agreement with life insurance: a cross-purchase plan and an entity-purchase plan.

Cross-Purchase Plans

A cross-purchase buy-sell agreement consists of each owner purchasing a life insurance policy on the other owner(s) of the business. The death benefit of each policy is based on the ownership percentage of each owner and the agreed upon value of the business. Here is a simple example:

Michaela and Emma own an equal share in their business, which is valued at $500,000. They are in the process of setting up a buy-sell agreement and have decided that the best option to fund this agreement is a cross-purchase plan. They will each need to purchase a life insurance policy on the other for $250,000 to fund the purchase of the other’s share in the business. 

While it sounds simple enough, a cross-purchase plan for a business with more than two to three owners can easily become extremely complicated. Because each owner must buy a policy on all of the other owners, you may find that your business would have to buy 10+ life insurance policies. For example, a business with four owners would require 12 life insurance policies total. 

Yikes!

Don’t worry, businesses with a number of owners still have another option: an entity-purchase plan.

Entity-Purchase Plans

In contrast to the cross-purchase plan, an entity-purchase plan consists of the business purchasing a life insurance policy on each of the owners. Again, the death benefit is based on the ownership percentage of each owner and the value of the business, but the business will be the entity purchasing the shares of the owner. One of the main benefits of this form of buy-sell funding is its simplicity for businesses with numerous owners. Let’s look at an example:

Jim, Bill, Hannah, and Emily are equal owners in a business valued at $1,000,000. They have decided against a cross-purchase buy-sell agreement because they would each have to buy three life insurance policies, or 12 total. In their entity purchase plan, their business will buy a life insurance policy on each of them for $250,000, or four policies in total. 

This may be much more manageable for your business and can help things go smoother should the buy-sell agreement need to be executed. However, the number of insurance policies is not the only thing to consider when deciding how to fund your buy-sell agreement.

Differences between Cross- and Entity-Purchase Plans

One large difference between a cross-purchase and entity-purchase buy-sell agreement is how an owner’s basis in the company will be effected upon execution. In the cross-purchase plan, one owner’s share in the business is purchased by the other owner(s), effectively increasing their basis in the company. This benefit is lost in an entity-purchase plan, because the business is purchasing the shares directly from the owner or the owners estate. Here is an example:

Michael and Ben are equal co-owners in their business and are deciding between a cross-purchase and equity purchase agreement. Their business is valued at $1,000,000 and they each have a basis of $250,000 in the company. Under a cross-purchase plan, they would each have a policy for $500,000 on the other owner’s life. If Michael dies, Ben will receive the $500,000 death benefit and use that to purchase Michael’s ownership in the company. He will effectively be increasing his basis in the company to $750,000 (initial basis + additional investment). 

Under an entity-purchase plan, the company would own the two policies and would use the death benefit to purchase Michael’s ownership from his estate. Ben’s basis in the company will still be $250,000, because he did not purchase Michael’s ownership interest.

As shown above, the cross-purchase plan is much more beneficial for the owners in terms of taxes. If the surviving owner wants to sell the company some time later, they may have a significantly higher basis and less taxable gains on the sale. 

Who Pays the Premium?

Additionally, there is a difference between how premiums are paid under these two plans. In a cross-purchase plan, the owners each pay for the policy on the other through their own cash flow. These premiums aren’t guaranteed to be equal, especially if one owner is significantly older than the other or has health conditions. 

The entity-purchase plan can be powerful in a situation like this, as the company pays the premiums for all life insurance policies involved in the agreement. This can help level the playing field and ensure that no owner is paying significantly more than another. 

When deciding what type of buy-sell agreement you should implement, it is important to look at all areas of your business’s, and your, financial situation. Book a call today to discuss how a buy-sell agreement can be implemented for your business.

Funding a Buy-Sell Agreement with Disability Insurance

Using disability insurance to fund your buy-sell agreement offers a number of benefits, namely the ability to receive the value of your ownership if you become unable to work or participate in the business prior to your retirement. In fact, there is about a 1 in 3 chance you may become disabled for six months or longer during the life of your career, and disability is more likely to occur than death during your working years. 

In many ways, using disability insurance to fund your buy-sell agreement is similar to using life insurance. There are still cross-purchase and entity-purchase plans, and you should still decide which of these to choose based on the needs of you and your business. However, the payout structure of a disability policy is significantly different, and the costs may be much higher. 

In this form of plan, when an owner becomes disabled, the disability policy held by the other owners, or the business, will fund the purchase of the disabled owners portion of the business. If you are not permanently disabled and are expected to return, the policy can even be used to continue paying your salary. Either way, you are provided a stream of income during your disability period. 

So What’s the Difference?

The biggest and most obvious difference is the event that needs to take place for the buy-sell agreement to be enforced. When a buy-sell agreement is funded with disability insurance, an owner must be found disabled for the policy to begin paying out. Even then, there is generally a waiting period that must be met before you receive benefits, so it is important to take this into consideration when structuring your buy-sell agreement. 

Additionally, because there are multiple definitions of disability, it is important to be sure that your policies and the agreement are consistent. If your buy-sell agreement stipulates that you are disabled if you can’t perform the specific duties of your job, but the policy says you are disabled if you can’t perform any occupation, the policy may not pay out when your agreement says it should. 

Setting up a buy-sell agreement with disability can be more difficult and expensive than using life insurance due to underwriting and the nature of disability insurance. Because disability is more likely to occur during your career, disability policies are generally more expensive than life insurance. This could put a significant strain on the other owners, especially if an owner has a health condition making disability more likely. Underwriting can also be a big issue for some businesses, as owners with health conditions may not be insurable in the eyes of the insurance company. Because of this possible complication, you should include an insurance agent in your group of experts as you set up a buy-sell agreement.

Using an Installment Sale to fund your Buy-Sell Agreement

An installment sale is simply an agreement that the buyer will pay a periodic principal payment, with interest, to the seller of the business. Generally, an installment sale is more risky than an agreement funded with insurance, as the seller is financing the purchase and trusting that the buyer can make the periodic payments. You should think carefully before entering into an installment agreement with a buyer, but there are some scenarios where it may make the most sense. 

An installment sale can be a good option for a business with strong and predictable annual cash flow when the business is the preferred buyer. If you and your partner(s) are not looking to add other owners to the business, but you would like to sell your ownership, you may look to the business itself to purchase your share. If the business has strong and predictable cash flow, you may feel confident that the business will not default on the payments while you exit. This may be especially powerful if you are unable to obtain disability insurance and are planning to sell your share upon retirement.

Family owned businesses may also find an installment sale is their best option. Because the parties are often related, getting the payment in full may not be a high priority and the seller may instead prioritize the ability to pass the business to a specific person. It is still important to create a reasonable payment plan, including an adequate interest rate, regardless of who the buyer is. 

One benefit of the installment sale is that you are able to spread the sale income, and any applicable taxes, over a period of time. This may allow you to limit the amount of taxes you pay on the sale and can provide you with an annual income stream, which can be very valuable if you are nearing or entering retirement. In contrast, a full cash sale may push you into a significantly higher tax bracket and reduce your take-home income from the sale. It can also have negative impacts on other areas of your finances, like your ability to make IRA contributions or increase your Medicare Part B premiums. 

The Risk of an Installment Sale

With an installment sale, you are taking on the risk that the business or individual buyer may default on their payment obligations. You should thoroughly vett your potential buyers to ensure that they have the ability to make the periodic payments and avoid a catastrophic event due to buyer default. In return for the risk you are taking, you can expect to receive adequate interest payments from the buyer, potentially increasing your overall return on your investment in the business. 

Buy-sell agreements are very important for your businesses succession plan, ensuring that you and your family are adequately compensated for your business should you retire, become disabled, or die. Because of their importance, you should be thorough in making your decision on how to fund the agreement, whether it be with insurance or an installment sale. 

A huge thank you to Bryce Thompson for authoring this piece.

Schedule a call to talk through these complicated decisions with a fiduciary Certified Financial Planner™

 

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