With any closely-held business, it is imperative that the shareholders have a plan to handle the exit, death or disability of any one of them. Many of our HNW clients who are shareholders in such companies have taken the first step of entering into buy-sell agreements that lay out what happens in these instances, but they have not taken the next step of formalizing how to fund the liabilities these agreements may create.
Without a plan in place, the remaining shareholders will have to rely on some combination of cash-on-hand, loans, and selling company assets in order to meet the liabilities triggered by a buy-sell agreement. A better option is to use cash value life insurance to fund the agreement, which can provide a large amount of capital and prevent disruption or dissolution of a business trying to pull together the needed funds.
When using cash value life insurance in this way, business owners usually choose between either a cross-purchase or an entity purchase plan. Let’s take a look at how each approach works, including their relative advantages and disadvantages.
Cross-Purchase Plan
In a cross-purchase plan, each shareholder purchases a life insurance policy on the other shareholders. Each shareholder pays the premiums on the policies they own on the lives of the other shareholders, and the policy-owning shareholder makes themselves the beneficiary of each of those policies.
At the death of another shareholder, the remaining shareholders will collect the death benefit from the policies they own on the deceased shareholder and use the funds to purchase the deceased shareholder’s interest from his or her estate.
If a shareholder departs a company, the cash value of the policies can be used to provide money to purchase the departing shareholder’s interest. The remaining shareholders may be able to give the policies they own to the departing shareholder as payment or partial payment for the shareholder’s interest. Then, the shareholder who has left can use the policies in their personal planning.
Stock Redemption Plan
An entity purchase plan is often called a stock redemption plan and is where each shareholder enters into an agreement with the company to sell their interest in the business. The company then purchases a life insurance policy on the life of each shareholder. When a shareholder dies, his or her shares can be redeemed by the company using the death benefit from the policy the company owns on that shareholder’s life.
If a shareholder were to leave, the company can use the cash value from the policy to help purchase that shareholder’s interest. Similar to what was described in a cross-purchase plan, the company can give the policy on the life of a departing shareholder as full or partial payment of the shareholder’s interest.
When addressing the disability of a shareholder, separate disability policies may be purchased under each of these plans. Conversely, the cash value from the life insurance policies may be tapped to meet the obligation.
For S Corporations, with proper utilization of a §1377 election, the surviving shareholders can receive an increase in basis. Family attribution rules do not apply to S corporations.
If Life Insurance Strategies Group can help you make decision regarding life insurance and your business, reach out to us at www.lifeinsurancestrategiesgroup.com.