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Most small business clients have two common—but often competing—goals when planning to exit the business: they want business-oriented successors to retain power over business assets while simultaneously providing for surviving spouses who have not been involved in the business. While controlling the line of succession can be relatively simple, it might unacceptably undermine the client’s ability to provide financial security for the surviving spouse. As an alternative to a traditional spousal lifetime access trust, the one-way buy-sell agreement can ensure that the client’s dual goals are met by providing spousal income security and an orderly business transition in a single package.
The Insurance-Funded One-Way Buy-Sell Strategy
In the family business context, the owner-operator frequently owns the majority—if not 100%—of the business’s interests. In the absence of proper planning, these business interests could potentially pass to family members with little or no business experience upon the owner’s death, which does little to safeguard the business’s future or provide long-term financial security to the owner’s family.
Enter the one-way buy-sell agreement, pursuant to which the owner is able to designate specific individuals who have agreed to purchase the business interests and continue the business upon death (or some other triggering event). The terms of the agreement should fix the value of these business interests so that the business can ensure that adequate funding will be available for the next generation to finance the purchase.
In conjunction with the agreement, the future successors then purchase a cash value life insurance on the business owner’s life that will fund the purchase price. The business can actually fund the policy itself by paying the successor-employees' bonuses or other compensation in order to pay the premiums. The compensation must be reported as income to the successors but is tax-deductible to the business.
Upon the owner’s death, the successor generation can use the life insurance proceeds to purchase the business interests from the owner’s estate which, in turn, can then distribute those proceeds to provide for the owner’s family according to his wishes.
Insurance as the Preferred Funding Method
Though insurance is not the only method that can be used to fund the buy-sell agreement, it provides a level of certainty that usually cannot be achieved through other methods. Relying on the buyer to personally finance the buy-sell agreement can present complications—namely, there is no guarantee to the owner that those funds will be available when needed.
Securing a traditional loan at the time of purchase also presents uncertainties, and the interest costs can significantly increase the actual purchase price, thus causing a loss of operating revenue for the business. Further, this method places an ongoing burden on the business’s credit that can inhibit the possibility for future growth.
Paying for the interests out of operating revenue, in installments over time, not only places a future strain on the business’s income but also fails to provide the owner’s estate with the funds necessary to provide for family members who are not involved in the business.
While cash value life insurance creates an ongoing current expense for the business, the premiums—if structured as reasonable compensation payments to the buyer-employees—are tax deductible. Further, if the strategy is implemented far enough in advance, the cash value that accumulates in the policy provides a degree of flexibility so that the buy-sell agreement can be funded using tax-free policy loans if the business must be transitioned before the owner’s death.
Coupled with traditional estate planning tools, an insurance-funded one-way buy-sell agreement can provide small business clients with the confidence of knowing that the future of the business—and the client’s family—is secure.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
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