Many closely held businesses do not make formal plans to transition the business in the event of the premature death of a business owner, the lifetime transfer or sale of the business, or the retirement of one of the key business owners. Lack of planning can cause a business to fail because of the significant changes that are brought about due to these triggering events. By using a cross-endorsement buy-sell plan funded with a permanent life insurance policy, the funds required to transfer the business efficiently will be available.

A cross-endorsement buy-sell plan is a private split dollar arrangement that provides the business owner and his or her family with the liquidity needed to transfer the business when one of the business owners dies prematurely. Alternatively, since the business owner owns the life insurance policy outright under this arrangement, he or she can access the policy’s potential cash value to supplement retirement income or to fund a lifetime buyout of the business due to disability.

Moreover, the plan may also provide the estate liquidity needed in the future to account for the wealth created from the growth of the business or from a successful public offering of the company’s stock. Because of its inherent flexibility, a permanent life insurance policy is an adaptable financial tool that can address a business owner’s changing needs over time.

How It Works

Under a cross-endorsement buy-sell arrangement, the business owner purchases and owns a life insurance policy on his or her life while the other business partners purchase and own policies on each of their respective lives. The value of each policy is based on the projected value of the business and each business owner’s proportional interest in the business. The arrangement is structured as an endorsement split-dollar plan so that a portion or all of the death benefit can be leased for a “rental charge” to the other business owners to satisfy the obligation under the buy-sell agreement.

Consequently, each business owner will recognize rental income on what they charge on their own policy, offsetting the net cost of the plan. The business owner as owner of his or her own policy continues to have access to the policy’s potential cash values. To minimize the cash outlay needed to pay premiums, the company may make annual bonus payments to each business owner in the amount of the premium.

The value of the rental charge is based on the economic benefit cost of the death benefit, which initially represents only a fraction of the premium. The economic benefit cost is measured annually using either a government or insurance company rate table that takes into account the insured’s attained age and the amount of the death benefit being endorsed.

Arrangements Between Irrevocable Life Insurance Trusts

Alternatively, the cross-endorsement buy-sell arrangement can be structured so that an irrevocable life insurance trust (ILIT) established by each business owner is the owner of the policy; and each ILIT endorses the death benefit to each of the other ILITs established by the other business owners. In this case, the business-owner-insured makes annual gifts equal to the premium amount to the trust that ideally qualify as tax-free gifts.

While the buy-sell plan is in place, the life insurance proceeds are to be paid to each surviving owner to fund the buy-sell obligation. However, if the plan is terminated for reasons other than death, the business owner can continue to own the policy and use the policy cash values to supplement retirement income or to fund a buy-out of the business. The policy can also be retained by the business owner to cover estate tax liability (see Chart 1).

Cross-Endorsement Plan Illustration

Consider Taylor James and Mark Lawson, who are each 50% owners of Tech Solutions Inc., which has been appraised at $4 million. Taylor (age 45) and Mark (age 46) are preferred underwriting risks and want their growing families to have the funds available to sell the business to each other should either one of them die prematurely. They also want flexibility to account for a buy-out before or at retirement or to cover the estate taxes that may be due as a result of the personal wealth the business creates.

Taylor and Mark enter into a buy-sell agreement in which each promises to buy out the other in the event of premature death. Each purchases a universal life insurance policy for $2 million and endorses or “rents-out” the death benefit on the policy to each other. The premium due on Taylor’s policy, based on 20 premium payments, is $23,694. Mark’s premium is $24,822 for 19 years (see chart 2).

The net cost of the plan is the same as paying the cost of a personal policy with no endorsement. When the buy-sell plan terminates, the endorsement will terminate and each owner will continue to own the policy and use it for their current needs. The cash value accumulation can partially fund a buy-out at retirement or supplement income. Of course, the policy death benefit can remain intact to provide the family with estate liquidity.

Clearly, a permanent insurance policy can go a long way in helping to transition the business if and when necessary and can provide business owners with the flexibility needed to account for changing needs.