Buy-Sell Agreement Funding
A written buy-sell agreement is important, but without a plan to fund it, it's just a great idea.
A buy-sell agreement is essentially the business equivalent of a combined will & advance directive (except instead of your own wishes, it's an agreement between the owners). In the event that an owner dies, retires, or becomes disabled, this agreement lays out how the business is to be valued and the process for dividing that owner's share. If the agreement is triggered but there's no funding (because it was never put in place, is insufficient, or has lapsed), the survivors are left to come up with the money on their own. The result is potentially catastrophic for the business, could put the owner's family in a position to take on responsibilities they don't want, or lead to disputes over the fate of the business.
This page explains how buy-sell agreements are typically structured, ways to fund them, and common mistakes business owners or inexperienced agents make, so you have a guide to what questions to ask--whether you are writing a new agreement or reviewing one already in place.
It's important to note: we are insurance professionals, not attorneys. This guide reflects our experience with buy-sell agreement funding, but it is not legal advice. We strongly recommend working with a licensed attorney to ensure that your agreement protects your interests, complies with applicable laws, and is in the appropriate form.
How buy-sell agreements are structured
We generally see two main types of agreements: cross-purchase agreements and entity-purchase agreements.
Cross-Purchase Agreements
In these agreements, each owner purchases life insurance on the other owners. If an owner dies, the surviving owners use the proceeds to purchase the deceased owner's share of the business. This structure works well for partners and two-owner businesses, but as the number of owners increases, so does the number of policies required. For a business with five owners, it would require 20 separate policies to cover all contingencies. While it's certainly possible to do so, it requires coordination to ensure successful implementation.
Entity-Purchase Agreements (Stock Redemption)
In these agreements, the business owns a policy on each owner, and the business itself buys out the deceased owner's share. This allows for a much smoother implementation as the number of owners increases. Only one policy is required per owner. Like anything, there are trade-offs. Because the business is the beneficiary of the policy and not an individual, there are tax implications to the proceeds and tax basis.
It's important to consult with a CPA or tax professional before executing either type of agreement so you understand how each would work out financially.
Hybrid or Alternative Agreements
Some agreements combine portions of these types, from having an LLC or trustee own the policies in a cross-purchase agreement to minimize the number of required policies to 'wait-and-see' policies, where the business decides later whether it wants to exercise the option to buy out the affected owner.
Buy-Sell Agreement Funding: How funding actually works
Once you've decided upon an agreement structure, it's time to decide on the source of funding.
Life insurance
Life insurance, unsurprisingly, is well-suited for covering the death of an owner. This is the most commonly used funding method due to its simplicity. With life insurance proceeds, the payout is typically income-tax free to the beneficiary, and funds are usually available quickly, allowing the business to continue without the stress of securing funding to buy out the deceased owner's share.
Disability Buyout Insurance
While buy-sell agreements commonly also address the owner's disability, an equally important but often overlooked funding source is disability buyout insurance. These policies pay out in the event of an owner's permanent disability. Without this coverage, the business would be required to secure the funds to buy out the disabled owner on its own.
Statistically speaking¹, it is far more likely for an owner to experience a long-term disability than to die prematurely. While businesses commonly purchase life insurance to mitigate the risk of an owner's death, few also insure against disability.
Cash Reserves or Financing
In the event the business is a high-cash-flow business or has significant liquidity, it may self-insure or plan to satisfy the agreement with its own cash. While this can work, the nature of business tends to result in ebbs and flows in cash flow, and can put a strain on the business's finances in the event of the unexpected loss of an owner.
Why regular review is required
Having an agreement is only the beginning. As with most important documents, it is important to revisit them at regular intervals to ensure they remain up to date, the underlying policies are accurate and in force, and ownership information is current.
Some of the common problems we see with these agreements:
Stale Valuations
Agreements commonly set a fixed buyout valuation, and/or a specific formula for calculating a future valuation. A business that has pivoted due to external factors (such as the pandemic) or which has had a significant change in volume (whether scaling up or downscaling) may not accurately represent a fair valuation or basis.
Ownership Changes
Ownership can change over time — sometimes additional owners are brought in, or current owners leave the business. If a new policy isn't secured for new ownership or policies aren't canceled for departing owners, the funding no longer aligns with the status of the business leadership.
Lapsed Policies
Business life policies are frequently paid annually, making it easy to forget or miss a payment, resulting in a lapse. Additionally, staffing or ownership changes sometimes result in the incoming staff not anticipating or recognizing the invoice, leading to it going unpaid.
Missed Notice Requirements (IRC §101(j))
Life insurance policies that are owned by a business (Employer-Owned Life Insurance or EOLI) trigger specific notice and other requirements. If the business doesn't complete the required paperwork before the policy is issued, the business may owe taxes on the policy proceeds — an expensive surprise when it's too late to correct.
Outdated Beneficiary Designations
Any time the business's structure or ownership changes, policy ownership and beneficiaries must be reviewed and updated immediately. If the business, an LLC, is the beneficiary but later incorporates, there could be issues collecting the policy proceeds, administrative delays, and potential tax implications.
Any one of these, discovered too late, could put the business and co-owners in an untenable position. What should be a document that protects the business and ownership quickly becomes a burden, creating unnecessary stress and financial strain during an already difficult time.
What we do differently
When handling a buy-sell funding case, we always ask to see the actual agreement, rather than relying on a recitation of terms by one or more owners. We do this not because we don't believe you, but because we want to ensure that the coverage we put in place exactly matches the terms of the agreement and that we present options for any possible risk outlined in the policy. We coordinate directly with your attorney and CPA, rather than working in isolation, to ensure the tax and legal mechanics are accounted for in the package we put together for you. We also include a recommended review schedule so that any adjustments can be made during a routine check rather than after it's too late.
For us, this isn't a one-time, set-it-and-forget-it transaction. Businesses change over time, whether in ownership, scope, growth, or valuation, and as a result, the funding behind the buy-sell agreement needs to be accurate.
Have a buy-sell agreement that is overdue for a review? Starting a business or need to put funding in place for a recently started business? We're happy to talk through your situation without pressure or obligation.
Next Steps
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¹ Source: Social Security Administration, Office of the Chief Actuary, Disability and Death Probability Tables...