You’ve spent decades growing your family operation. Now you want to ensure that your family, business partners and employees will be taken care of if you’re no longer able to be there. You have a child (or several) helping run the day-to-day operations. You may also have other children not working in the family business, but you still want to find a way to be fair to them. Life insurance can provide the liquidity you need to make it all work. Perhaps a buy/sell agreement funded with permanent life insurance, along with a second-to-die policy on you and your spouse, could be the strategic insurance solution to put your mind at ease…and protect what you’ve built.
What is a buy/sell life insurance agreement?
A buy/sell agreement funded with life insurance is legal agreement between the current generation owner and the next generation that will be taking over the operation. The buy/sell life insurance policies will be used at the death of either owner to provide tax-free cash to purchase the ownership shares of the deceased partner from their beneficiary. The surviving owner now owns the entire operation unencumbered by debt and without losing cash flow to make payments to the deceased owner’s beneficiary.
How does a buy/sell life insurance agreement work?
When taking out a buy/sell life insurance agreement, business partners purchase life insurance policies on the lives on each co-owner, but not on themselves. If a co-owner dies, other co-owners are paid a lump-sum benefit that’s forwarded to the deceased’s surviving family members. This payment allows the owners to acquire the share of business from the deceased while compensating grieving family.
What are the benefits of a buy/sell life insurance agreement?
Advantages of a buy/sell life insurance agreement include:
- Mutual benefits - Not only does the deceased’s family benefit from this agreement, but the operation also doesn’t suffer financial loss.
- Instant Liquidity - At the time of death, the policy instantly provides liquidity that can be used to fund the buy/sell agreement so all parties can perform on their financial obligations to each other without putting the future of the operation at risk.
Why do people put buy/sell insurance agreements in place?
A buy/sell agreement is an integral part of the business planning process. When a business partner dies, this type of insurance agreement can protect the business for the surviving partner and provide much needed liquidity for the surviving dependents of the deceased partner.
Buy/sell agreements are typically structured in one of the following ways:
- Cross-purchase agreement. The co-owners purchase the insurance policy on the other owners. When a co-owner dies, the death benefits of the insurance agreement are used by remaining co-owners to purchase the deceased’s company shares.
- Entity redemption agreement. The operation buys the life insurance policy for each co-owner and can use the benefits to purchase the shares of the deceased co-owners from their heirs or estates.
- Hybrid agreement. A combination of two types of agreements, it’s enacted when co-owners offer their shares to the operation. If the operation declines the offer, other co-owners can purchase the shares. Other long-time employees could also be given the opportunity to purchase the shares.
What is a second-to-die policy? How does it work? Why do I need one?
Now that your buy/sell is in place, how do you equalize the inheritance you want to leave to your children who are not working in the business? How do you plan on funding the potential state and federal estate taxes that could be due upon the death of both you and your spouse?
Second-to-die life insurance is one policy that insures both you and your spouse’s life. The death benefit won’t pay out until the second person passes away, which is when the estate tax is triggered. Buying insurance in this manner is significantly less expensive than buying a separate policy on each person. Plus, the need for liquidity isn’t there until both of spouses pass away. Most of our high-net-worth clients finance their second-to-die policies due to the efficiencies they get from the financing.
Example: Your Business is worth $25M. Your overall net worth is $35M. Your oldest two sons help you run the operation and will take over when you’re gone. Your other son and two daughters have no interest in the business…and your two sons at the business have no interest in having those siblings on the payroll or attempting to make business decisions. But you want to leave an equal inheritance to all of your children.
You and you spouse buy a second-to-die life insurance policy for $15M. At both of your deaths, the two boys inherit the business 100% (a $25M value). The other three children will split the additional $10M of net worth you guys have, plus the $15M in life insurance for a total of $25M. Now that may not be equal, but it is fair. Of course, you could plan to leave the other three children $12.5M each (that's what the two other sons are inheriting). In that case you’d buy a $27.5M policy to add to the $10M of liquid assets the other three children will inherit.
Remember, life insurance death benefits are generally tax free when the policies are structured appropriately, but it's important to consult your tax professional.
Depending on what the current administration does with the tax code, a family business may face substantially higher taxation at the transfer of assets from one generation to the next. There is talk of eliminating the step-up in cost basis that the new generation currently receives when inheriting an capital asset. This is another example of where a second-to-die life insurance policy can help. Again, at the death of the second spouse, the policy pays the death benefit (typically to your trust), to be used to pay all of the taxes, so your children can keep the business without worrying about how to come up with the money to pay such a high tax liability.
In conclusion, this type of life insurance strategy, can significantly improve the process of transitioning assets from one generation to the next, paying estate taxes, equalizing an estate amongst heirs or funding buy/sell agreements between generational owners/partners. Using premium financing enhances the power of insurance when designed and executed correctly. We look forward to helping you with your specific situation.
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