A Primer on Buy-Sell Agreements and Buy-Sell Insurance

Katie Fleming

Katie Fleming

Co-founder and COO of Owner Actions

Two people sit at a desk discussing buy-sell agreements

Are you a co-owner or a partner in a small business? If so, you might consider buy-sell agreements or a buy-sell insurance policy as you work through the succession planning process. In this article, we'll explain the key points of both of these enforceable legal contracts.

Important note: This article should not be construed as legal or financial advice. It's imperative that you speak with an attorney, accountant, and financial planner who can help you navigate your succession and prepare legal documents that suit your specific circumstances and goals.

 

What is a buy-sell agreement?

There are lots of reasons for a one business owner to exit a business. An owner may die, file from divorce from another partner, file for bankruptcy relief, become incapacitated, or be fired from the role they have in the business.

When one of these events occurs, you can use a buy-sell agreement to ensure that the exiting owner's shares cannot be sold or transferred to another party. With this agreement, the remaining business owner(s) have the right to buy the exiting owner's interest. Some agreements take it a step further, requiring the remaining owners to purchase the exiting owner's interest to prevent anyone outside the company from buying or inheriting a piece of the business.

It's important to note that your buy-sell agreement needs to be in place before one of these triggering events occurs. Often, owners draft buy-sell agreements during the succession planning process, and they accomplish it with either a stand-alone contract or fold it into their operating agreement, partnership agreement, shareholder agreement, or another business agreement.

An attorney can help you work through the terms you should keep in mind, including how to value the exiting owner's interest at the time of the transfer.

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How does life insurance come into play with a buy-sell agreement?

The owner(s) who stay with your business could use their own money to buy the exiting owner's interest, and this is usually what happens with many of the circumstances in which one owner exits. But when the cause of the owner's exit is death, a life insurance policy can help them cover those costs.

Owners who depend on life insurance for these costs can run into some complications. One common stumbling block occurs when the owner of the life insurance policy that'll be used in this agreement isn't titled as the party who has the right to purchase the deceased owner's shares.

For example, suppose the buy-sell agreement states that the entity has the right to purchase a deceased owner's interest. In that case, the company should own and be the sole beneficiary of the life insurance policy. On the other hand, if the remaining owners have the right to purchase the interest in their personal names, each owner would purchase a life insurance policy for each of the company owners, naming himself or herself as the beneficiary.

 

What are the benefits of using life insurance policies in this way?

Through life insurance, beneficiaries can gain almost immediate access to funds to purchase a deceased owner's interest. And, often, the death benefits from a life insurance policy aren't subject to income tax.

Provided that the life insurance payout is equal to or greater than the owner's interest in the business, beneficiaries can avoid the lengthy and costly process of taking out interest-bearing loans or securing other forms of financing to cover a departing owner's interest. And while the remaining owner(s) may pay premiums on a life insurance policy, the premium will likely be substantially lower than the total cost of a loan or another form of financing.

 

What about the risks?

There may be financial risks in using this method to fund a buy-sell agreement. Because of this, you should speak with an attorney and an accountant about the best way to fund a buy-sell agreement and use insurance policies based on your unique situation.

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Where can I attain a life insurance policy?

Your current business insurance agent may have a recommendation. You could also use one of these online platforms to set up life insurance policies:

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