Small businesses are an important part of our nation’s economy. In the current environment many small business owners are focused on securing new customers, weathering the impacts of the pandemic and being flexible in a time of constant change. Planning for the future may not be at the forefront of their minds, but having a financial professional to help them protect their business for the future can free them up to focus on operating concerns. Helping your business owner clients with succession planning can add value to your relationship. Using life insurance you have access to tools and strategies that can help a small business survive into the next generation.
One of my go-to strategies for small business owners is a buy-sell agreement. A buy-sell agreement fully funded with life insurance greatly increases the company’s chances at ongoing survival after an owner’s death, disability or retirement. There are a few versions of buy-sell and each has strengths and weaknesses. My personal favorite is a buy-sell LLC (Limited Liability Company), as it eliminates some of the complexity you’ll find in other types of agreements.
What a buy-sell agreement does for a business owner
A buy-sell agreement can facilitate the transfer of business interests when certain specified events, like death, retirement, or disability, occur with one of the business owners. It is a legally binding contract that obligates the parties involved to either sell or purchase the business and stipulates how the partner’s share of a business may be reassigned if that partner leaves the business. A big question for the financial professional, and often a sticking point for the business owner, is how the agreement is funded.
Types of buy-sell agreements
There are generally two types of buy-sell agreements. The first is a cross-purchase agreement in which the business owners acquire life insurance policies that cover the other owners. In this case, the agreement ensures there is an obligation for the remaining business owners to purchase the interest and the deceased owner’s family to sell the business to the remaining owners. The life insurance policy provides the funds for the surviving owners to make the purchase.
Business owners typically like the cross-purchase arrangement, as it is easy to understand and accounts for death, disability, retirement or even divorce of one of the business owners. The disadvantage of creating a cross-purchase arrangement comes when you have more than two business owners. The number of policies needed to complete the process grows exponentially when there are more than two, as each owner has a policy on the other owners. (For example, if a business has four owners, each owner has a policy on each other owner for a total of 12 policies. If a business has five owners, a cross-purchase arrangement results in 20 policies, and so on.)
The other typical buy-sell arrangement, the entity purchase agreement, alleviates the complexity of too many owners and life insurance policies because the business is the owner of the life insurance policy. The company takes out an insurance policy on the lives of owners in the amount equal to each owner’s interest in the company. In the event of a death, the amount collected by the company from the insurance policy, which is equal to the deceased owner’s stake, is used to pay the deceased’s estate for its share of the business. The company will continue to be run by the remaining partners. The entity purchase however does not allow for the tax preferred step-up basis that you find in the cross-purchase arrangement.
Benefits of the buy-sell LLC
My go-to strategy for business owner clients is a buy-sell LLC. By establishing a new or existing limited liability company (LLC) to own life insurance policies, you create an arrangement that has all the advantages of standard buy-sell planning while effectively eliminating some of the disadvantages of a cross-purchase or entity-purchase arrangement.
With the buy-sell LLC, similar to the entity purchase, you have one life insurance policy owned by the business. And, like the cross-purchase arrangement, surviving owners in a buy-sell LLC will receive a tax preferred step-up in basis as well as access to cash to be used to provide flexibility in succession planning.
Overview of the process to create a buy-sell LLC
The structure of a buy-sell LLC is fairly straightforward. First, you should understand your client’s goals and identify the need for a buy-sell LLC. Then determine the terms of the agreement with the business owners who will be involved.
When you’re ready to implement a buy-sell LLC strategy, the business owners execute a cross-purchase buy sell agreement utilizing a LLC to own a life insurance policy on each owner. The owners then contribute to the LLC capital account and the LLC pays the premiums on the life insurance policies for each owner. The life insurance policy is protected from the business’s creditors.
Upon the death of an owner, the LLC, as a beneficiary of the life insurance policy, will pay the deceased owner’s estate an amount equal to the deceased’s ownership interest. The deceased owner’s estate will then transfer ownership shares to the surviving owners. The business owners, as members of the buy-sell LLC, have access to cash values of their own policy through loans and withdrawals which can help fund retirement needs for retiring owners or to buy out an owner who is exiting the business.
If an owner retires or the business terminates, the LLC can be terminated and policy ownership can be transferred to each remaining business owner tax-free.
Failure to plan can be costly for small business owners. A buy-sell agreement, fully funded with life insurance, can greatly increase a company’s ongoing survival after the death of an owner or even disability or retirement. The simplicity of a buy-sell LLC makes it an attractive choice to your business owner clients. Knowing how to implement this strategy with scheduled revisiting that takes into consideration any growth plans the company has can be a key to your success.
Prior to implementing any strategy like a buy-sell LLC, your clients would be wise to consult with their tax and legal advisors regarding their situation and any potential consequences for using a buy-sell strategy.