Business Owners Suite · Buy-Sell
Business Transition
A buy-sell plan has two parts. The legal plan is written by an attorney. The funding is what makes it real. One of the most common funding sources is a life insurance policy, so the money to complete the buyout arrives on the day the agreement is triggered rather than years later out of company cash flow.
Worth Knowing
Three of these come straight from the carrier documents that sit behind these agreements. They rarely make it into the conversation, and each one changes the answer.
Under an entity purchase the business owns the policies, so the policies and their cash values are subject to the claims of the business's creditors. Under a cross purchase the policies are not owned by the business, so they are not business assets and are not exposed the same way. Same death benefit, very different protection.
Source: North American Company for Life and Health Insurance, Buy-sell with life insurance, 215NM-3a
Proceeds from a policy the business owns are generally received free of federal income tax. If the policy does not meet the notice and consent provisions under Internal Revenue Code section 101(j), the proceeds above the premium paid are instead included in the employer's income. That is a document requirement, not a product feature, and it is the kind of thing found too late.
Source: North American Company for Life and Health Insurance, Buy-sell with life insurance, 215NM-3a
A buy-sell specifies its triggering circumstances, and the usual three are retirement, death, and disability. If the policy funding the agreement is a properly funded cash value policy, the cash value could also help buy out a retiring owner. The same instrument covers the exit you plan and the one you do not.
Source: North American Company for Life and Health Insurance, Business Planning: Buy-Sell Agreement, 1804NM-9
| Entity purchase | Cross purchase | |
|---|---|---|
| Who owns the policies | The business owns a policy on each owner | Each owner owns a policy on every other owner |
| Who pays the premiums | The business | The owners, though the business can fund the premiums through a bonus plan |
| Premium deductibility | Not deductible, because the business is the beneficiary and holds an interest in the tax-free death benefit | The owner-employee is responsible for federal income tax on the bonus |
| Exposure to business creditors | Policies and cash values are subject to the claims of the business's creditors | Not business assets, so not subject to those claims |
| Corporate AMT | For C corporations, the Alternative Minimum Tax may apply to death benefit and cash value above policy cost basis | No corporate Alternative Minimum Tax, because the business does not own the policy |
| What the heirs receive | A pre-determined price for the deceased owner's share | A pre-determined price for the deceased owner's share |
Source: North American Company for Life and Health Insurance, Buy-sell with life insurance, 215NM-3a
The Structure
What it does
The agreement names who buys the departing owner's interest, on what terms, and at what valuation. The family of the owner who leaves gets cash rather than a minority stake in a company they do not run. The owners who remain keep control.
What has to be true
An obligation to buy is only as good as the ability to pay. Company cash flow, a bank line, and an installment note are all possible, and all of them arrive after the event. A policy on each insured owner is the one funding source designed to be there the same week.
Where it comes apart
Most failed buy-sells were signed correctly. The company then tripled in value and nobody revisited the number, or an owner was added and never brought into the arrangement, or the funding lapsed quietly. The document and the funding need to be reviewed on the same schedule.
An agreement with no funding behind it is a promise. Funding with no agreement behind it is an accident. Your attorney writes the first half. This practice builds the second, and makes sure the two match.
Begin the Conversation
Whether your agreements are drafted, outdated, or still an intention, this conversation is private, unhurried, and specific to your company.
Important: This page is general education. It is not legal, tax, accounting, or individualized financial advice. Buy-sell agreements, split dollar arrangements, deferred compensation plans, and trusts should be drafted by a qualified attorney, with tax treatment confirmed by a qualified tax professional. Life insurance policies contain costs, charges, limitations, exclusions, and conditions; coverage depends on underwriting and on the terms of the policy issued. Guarantees are backed by the claims-paying ability of the issuing insurance company. Policy loans and withdrawals reduce cash value and death benefit, are subject to interest charges, and are generally not subject to income tax provided the contract is not a Modified Endowment Contract as defined by Section 7702A of the Internal Revenue Code. Distributions from a Modified Endowment Contract are taxable to the extent of gain and may carry an additional tax before age 59 and a half. Carrier material referenced on this page is cited to its published form number.