Buy-Sell Planning For Unhealthy Business Owners

In the course of designing a business continuation plan, many times one of the partners or stockholders may be either uninsurable or heavily rated.

This, however, should not stand in the way of completing the development of a buy-sell plan. In fact, if one of the owners has impaired health, implementation of a business purchase plan becomes even more imperative.

In the case of a business owner who is rated but still insurable, issuance of the policy and payment of the rated premium is usually the wise course, since the amount of rating attached to the premium represents a fair assessment of the owners shorter life expectancy. But if the rated premium is more than can be afforded or if the business owner is completely uninsurable, then other solutions will have to be found.

There are a number of possible ways to approach this problem. Most of these strategies are based on the idea that some sort of sinking fund is desirable to provide the funds that will be needed to purchase the business interest of the uninsured owner at his or her death. If the solution involves an insurance company product, there are certain advantages not found in other methods.

Two methods that do not use a sinking-fund approach anticipate settling the obligation created by the death of an owner with cash taken from the then-existing assets of the business or with an installment payment of the purchase price. Both of these methods suffer from uncertainty. The owners death may create other demands on the businesss cash flow that will make it impossible to buy out the owners business interest. Installment sale agreements may not be completed because successor management may be unable to generate sufficient earnings to pay the obligation.

Here are some alternative methods that may prove to be more attractive to the uninsurable business owner.

Using Existing Insurance

If the uninsurable business owner has surplus personal insurance, this can be used to fund the buy-sell agreement. When a policy is transferred to a partner, a partnership or a corporation, the problem of the “transfer-for-value” rule under Internal Revenue Code Section 101(a)(2) is avoided since these transfers are exceptions to this rule. Be aware, however, that the transfer of existing insurance owned by a stockholder to a co-stockholder to fund a stockholders cross-purchase agreement will “taint” the policy under the transfer-for-value rule.

Borrow A Life

It may be possible to own insurance on the life of someone other than the business owner as the funding vehicle. For example, a key employee who is about the same age as the uninsurable owner could be the insured for a buy-sell policy. Or, in instances where appropriate, even the business owners spouse may be used.

Under the entity approach, the partnership or the corporation applies for the policy as owner and beneficiary. If the non-owner insured dies first, the proceeds are paid to the business, income tax-free, and will be on hand when needed to purchase the interest of the uninsured at his or her death. If the uninsured business owner dies first, there is an accumulation in the loan value of the policy available to make at least a partial payment on the purchase of his or her interest.

Under the cross-purchase approach, the insured could be the spouse of the uninsured. A typical crisscross policy ownership arrangement would be used. The uninsured business owner would insure the lives of the insurable owners. They, in turn, would insure each other and also the spouse of the uninsured business owner. If one of the insured associates dies first, the policy proceeds become available for the purchase of his or her business interest. If the uninsured dies first, the loan value of the policy on the spouses life is available as partial payment toward the purchase of the interest. If the spouse of the uninsured dies first, the policy proceeds can be held by the insured associates for the purchase of the uninsured owners business interest at his or her death.

Increasing Insurance On Insurable Owners

Under the entity approach, the business would increase the amount of coverage on the insurable business owners. The business pays the entire premium and is beneficiary of the proceeds. The increased insurance negates any need to create a separate fund for the purchase of the uninsurable business owners interest. If one of the insurable business owners dies first, the business will receive enough proceeds to purchase the deceaseds interest. In addition, this will immediately create a fund to buy out the uninsurable business owners interest at his or her subsequent death. If the uninsurable business owner dies first, the business will own policies with substantial cash values available for the acquisition of the decedents interest.

Under the cross-purchase approach, two policies are purchased on each insurable associates life. The uninsurable business owner buys and pays for one policy. The other policy is owned and paid for by the other insurable associate. If one of the insurable business owners dies first, the proceeds of the policy owned by the uninsurable owner are available to purchase the deceaseds interest. In that case, the “additional” coverage owned by the insured associate can be used for estate liquidity or family income purposes. If the uninsurable owner dies first, the insured associates will have the cash value in the policy to make partial payment for the purchase of the deceaseds interest.

Patrick F. Olearcek, JD, is director of estate and business planning for MassMutual Financial Group. He is based in Hartford, Conn., and can be reached via e-mail at polearcek@massmutual.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 20, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.