Buy Sell Insurance – Protection, Transition, and You
KEY POINTS
Strategic Buy Sell Insurance
Buy sell insurance protects private investors, ensuring survival, boosting valuations, and securing employee retention during ownership changes.
Tailored Risk Management
Choosing between buy sell life and disability insurance tailors risk management, offering precise financial stability for scenarios like death or disability.
Navigating Nuances
Success lies in navigating policy nuances - type, amount, coverage, beneficiary, creditor protection, age, health, and taxation - crucial for an effective buy sell insurance strategy benefiting owners, families, and employees.
Did you know?
Buy sell insurance can be an important component of your integrated insurance strategy, and may,
Increase your company’s survival rate
Increase your company’s market valuation
Increase employee retention during ownership changes
Increase your company’s ability to secure financing
Facilitate unexpected transitions
Minimize anxiety and conflict amongst family members and business partners
Who should consider buy sell insurance?
Shareholders of privately held companies and partners within a partnership should consider how buy sell insurance can integrate into their personal estate plans and corporate strategic plans.
What is buy sell insurance?
Investors in private ventures will often enter into a buy sell agreement. These agreements are designed to facilitate the reallocation of an investor’s equity or partnership interest upon their demise, their decision to divest (e.g., retirement, bankruptcy, divorce), or in the event of them becoming disabled.
The funding requirements to successfully execute the buy sell agreement can create liquidity constraints for the company and the remaining investors.
Buy sell insurance contracts can be an effective funding mechanism to ensure the buy sell agreement is executed in a timely and efficient manner while minimizing disruptions.
How does a buy sell agreement work?
There are generally three types of agreements.
Cross Purchase Method
The objective is for the remaining investors to purchase the equity or partnership interest of the divested investor at fair market value.
This is accomplished by each investor taking out an insurance policy on the other investor(s) and appointing themselves as the beneficiary. The insurance proceeds received by the individual are utilized to purchase the equity or partnership interest from the individual, their surviving spouse, or their estate.
The entity redemption method or the promissory note method discussed below may be preferrable in the cases involving multiple shareholders or partners,
Entity Redemption Method
The objective is for the entity to purchase the equity or partnership interest of the divested investor at fair market value.
This is accomplished by the entity taking out an insurance policy on each investor and appointing the entity as beneficiary. The insurance proceeds received by the entity are utilized to purchase the equity or partnership interest from the individual, their surviving spouse, or their estate.
Promissory Note Method
The objective is for the remaining investors to purchase the equity or partnership interest of the divested investor at fair market value.
This is accomplished by the entity taking out an insurance policy on each investor and appointing the entity as beneficiary.
At the time of divestment, the remaining investors purchase their share of the equity interest from the individual, their surviving spouse, or their estate. Initially, this transaction is facilitated with a promissory note.
The insurance proceeds will be received by the entity and are paid out to the remaining investors. Upon receipt, the investors will utilize the proceeds to fulfil their obligations under the promissory note.
Hybrid
Some investors may elect to use a combination of the Cross Purchase Method and Promissory Note Method.
Insurance Plan Options
There are two primary insurance plan options that can be utilized for funding purposes.
Buy Sell Life Insurance
These policies are designed to generate funding in the event of an investor’s death. Coverage amounts can be substantial. The life insurance policy choices may include term life, whole life, and universal life.
Buy Sell Disability Insurance
Disability insurance policies are designed to generate funding in the event of an investor becoming disabled as defined by the policy. Coverage amounts can be significant. The insurance proceeds may be paid out in a lump-sum, by installments, or a combination of the two.
Policy Dynamics
Buy sell insurance contracts possess the following nuances,
Policy Type
The choice of insurance policy should be based on the unique facts and circumstances of the parties involved. Term life policies are often utilized as they typically cost less, and their primary purpose is to provide a lump-sum benefit payout. However, a whole life or universal policy has an investment element that may be more appropriate under certain circumstances.
Benefit Amount
The initial benefit amount specified in the insurance policy may be sufficient at inception but become insufficient if the company’s valuation increases over time.
Some policies may have an imbedded increasing benefit amount. Or they may permit the policyholder to purchase additional coverage subject to predefined conditions.
Coverage Period
The policyholder is at risk of the insurance policy expiring while the coverage is still required. Renewals can be substantially more expensive. Policyholders may not be offered the ability to renew due to poor health. Some policies offer guaranteed renewability at preset rates.
Beneficiary Intent
The underlying assumption of formalizing a buy sell agreement backed by insurance is that the beneficiary will utilize the proceeds to facilitate the buyout. The risk of beneficiary deviation (i.e., utilizing the proceeds for alternate purposes) increases if the beneficiary is an individual as opposed to the business entity.
Creditor Protection
Insurance proceeds received by a corporation under either the entity redemption method or promissory note method could be at risk of creditor claims. Prudent corporate structuring can minimize this risk.
Age and Health
The cross purchase method requires the individuals to purchase life insurance for the lives of their fellow investors. The cost of such individual policies can vary dramatically based on the insured’s age, health, family history and more. The premium variances can be substantial and lead to animosity amongst investors. This issue can be avoided if the business owns the policies and pays for the premiums.
Taxation
The tax implications of buy-sell agreements, particularly those funded by life insurance, are closely linked to the corporate structure and the tax status of individuals involved.
Insurance proceeds received by beneficiaries are generally tax-free. However, the tax treatment of insurance premiums varies, and premiums paid by a corporation may not always be tax-deductible.
Importantly, depending on the corporate structure, there's potential for the corporation to pay out the insurance proceeds to its shareholders tax-free via a dividend, providing an additional layer of tax planning.
Individuals should thoroughly assess the tax consequences of the insurance component within buy-sell agreements, considering the corporate tax framework and exploring strategies that optimize the overall tax outcome.
Buy Sell Insurance vs. Key Person Insurance
The world of insurance can be confusing and complex. The following table is designed to provide clarity and promote sound decision making.
|
Criteria |
Buy Sell Insurance |
Key Person Insurance |
|
Purpose |
Protect business owners / partners in case of death or disability |
Protect the business from the financial impact of losing a key employee |
|
Estate Planning |
Can facilitate a structured and planned transfer of business ownership, providing liquidity for estate settlement |
May contribute to estate planning by ensuring the business has financial stability in the event of a key person’s loss |
|
Business Ownership Transition |
Ensures a smooth transition of business ownership |
No direct on ownership structure; focuses on the financial stability of the business |
|
Coverage |
Financial interests in the event of the death or disability of an owner / partner |
Financial loss associated with the death or disability of a key person in the business |
|
Beneficiaries |
Typically, the business or remaining owners / partners |
The business itself if the beneficiary |
|
Trigger Events |
Death or disability |
Death or disability |
|
Funding Source |
Business or owners / partners |
The business pays the premiums |
|
Employee Retention / Attraction |
No direct impact; however, may have indirect impact |
Helps attract and retain talent by providing financial stability |
FINAL THOUGHTS
Buy sell insurance can prove instrumental for private investors, providing benefits beyond risk mitigation. It enhances a company's survival rate, market valuation, and employee retention during ownership changes.
Advisable for shareholders and partners in private companies, integrating buy sell insurance into estate and strategic plans is key. The choice between buy sell life insurance and buy sell disability insurance depends on specific needs.
Successfully implementing buy sell insurance requires navigating policy dynamics, including type, amount, coverage, beneficiary, creditor protection, age, health, and taxation.
An integrated strategic approach can yield benefits for business owners, their families, and employees.
