This article speaks to a ready market. Why? Because statistics suggest that 80% of all small and mid-sized businesses in the country have made no adequate plans for transition in the event of one owner’s retirement, long-term disability, or premature death. And “adequate” includes being properly reduced to writing. All the understandings and oral agreements in the world are not worth the paper they should have been written on. Tell every transition-planning resistant client that they go to bed every night not knowing who will be their business partner when they wake up!
In addition, and perhaps most critically, there are no arrangements regarding the rights of a co-owner if another owner decides to sell out to a third party. Again, ask every transition-planning resistant client you have how they would like to get out of bed only to find they are in bed with their competitor.
But the focus here is only about one planning concern when purchasing life insurance to fund the agreed-upon buyout of a deceased owner: avoiding an unmanageable multiplicity of policies.
It usually makes sense to structure the buy-out outside the company through a “cross-purchase” agreement among the owners.
This assures that the full purchase price will be reflected in the increase in basis of the surviving owners.
In a cross-purchase each owner must own a piece of the insurance on all the other owners to buy a proportionate share should any other die first. If there are only two owners it’s a cake-walk. Each has a policy on the other. But things get exponentially burdensome as the number of parties increase. Three owners would require 6 polices, 4 owners need 12, and on it goes.
If the business is a partnership or an LLC taxed as a partnership there is an easier way.
Simply purchase one policy on every owner and have each held by the non-insured owners jointly-with-right-of-survivorship. On the death of one of the joint policy owners the rights to the death benefit are automatically reapportioned among the survivors. And since they are “partners” the reallocation of interests in the policy does not raise transfer-for-value issues.
But all must understand that anytime personally owned policies are used to fund a buy-sell agreement things only go smoothly when everyone fulfills their obligations – i.e. the estate sells the interest of the deceased owner and the survivors use the death proceeds to make the purchase from the estate, all under the terms of the agreement.
If the parties to a buy-sell are uncomfortable with personal ownership or the business structure doesn’t lend itself to protection from possible transfers-for-value (C-Corp, S-Corp, or an LLC taxed as a C-Corp or an S-Corp) then the policies are commonly held in an LLC or a partnership created for that purpose.
Contact me with any questions that arise in your casework involving business transition planning, and ask for our simple 4-page summary of business planning issues including the considerations that should be addressed in a well-constructed buy-sell agreement – either call at 706-354-0401 or email at firstname.lastname@example.org.