With day-to-day operations of running a business, one of the challenges we see for business owners is shifting their focus to succession and/or exit planning. This shift in focus can involve implementing the proper safeguards to protect the business from unforeseen events such as death or disability of an owner or key employee. Access to cash is critical at the loss of a business owner, partner, or key person. A buy-sell agreement is a contract among owners to buy a deceased owner’s stock/shares of the business at a previously agreed upon price (or valuation method) in the event of death, disability, or retirement. Life insurance can be an inexpensive way to fund buy-sell agreements as well as to protect against the loss of a key employee.
In the event of a sudden death, a properly structured and funded buy-sell agreement will keep a company’s business partners from having to scramble to come up with the money to buy out the decedent’s shares of the business. Additionally, this agreement places a mechanism to help ensure that the deceased partner’s survivors will be compensated fairly and promptly. Buy-sell agreements are typically funded by life insurance policies purchased on the lives of each of the partners and the amount is usually specified in the agreement based on a current valuation or valuation method. Depending on the number of partners and other considerations such as age and health, a cross-purchase or an entity-purchase buy-sell agreement is typically recommended.
For sole proprietors, a one-way buy-sell agreement can be created to transfer ownership to a key employee or family member.
Types of Buy-Sell Agreements
Cross Purchase Plan
- Each partner owns, pays individual premiums, and is a beneficiary of a policy on the life of the other partner(s).
- Premiums are not tax deductible to the partners; if the business pays the premiums, it is recognized as a deduction to the business, and so becomes taxable income to the partner(s).
- Death proceeds received by the surviving partner(s) are tax-free income.
- Basis of the purchasing (survivor) partner(s) is increased by the price paid for the decedent’s interest.
Redemption or Entity Plan
- The business owns, pays for, and is the beneficiary of the policies.
- Premiums are not tax deductible to the business.
- At the partner’s death, the business receives tax-free income death proceeds to purchase the business interest from the deceased owner’s estate.
- Typically there is no increase in basis to the surviving partner(s). Value of survivor partner’s stock is increased but not the basis.
- Sole proprietor or business owner establishes a buy-sell agreement with key employee(s).
- The key employee(s) owns, pays for, and is the beneficiary of the life insurance policy.
- The premiums may be shared by both parties.
- At death of owner, the key employee(s) receives the tax-free income death benefit to purchase the deceased owner’s business from the estate.
The goal of each agreement is to provide structure and funding for a harmonious transfer of the business interest. A cross purchase plan tends to be the preferred structure for businesses with three or fewer owners/partners; while a redemption or entity plan tends to be the preferred structure for businesses with three or more owners/partners.
Key-Person Incentive Plans
Non-Qualified Supplemental Retirement Plans
Non-qualified plans allow employers a way to attract and retain key employees by offering supplemental retirement benefits. Benefits can be provided from company earnings, a sinking fund, or permanent life insurance. The following arrangements can be funded with permanent life insurance or a side fund investment.
Executive Bonus Arrangement
- The employer pays the premium on permanent life insurance purchased by the employee. The premium payments are tax deductible as compensation and taxable to the executive, as a bonus. The executive is the owner and has full control of the policy.
- Cash value provides tax-favored supplemental income during retirement.
- As a result of the executive’s death, beneficiaries receive tax-free income death proceeds.
Collateral Assignment or Endorsement Split-Dollar Arrangement
- The employer and the executive enter a split-dollar agreement drafted by legal counsel.
- The employer purchases cash value life insurance on the life of the key executive and pays the nondeductible policy premiums. The executive recognizes the tax on the economic benefit (term insurance) or loan interest.
- At retirement, the employer releases the collateral assignment or transfers the ownership of the policy. Cash value provides supplemental income during retirement.
- At the time of the executive’s death, the employer receives a portion of the tax-free income death benefit equal to total premiums paid. The executive beneficiaries receive the remainder tax-free income death benefit.
Non-Qualified Supplemental Executive Retirement Plan (Deferred Compensation)
- The employer purchases and owns a cash value life insurance policy on the life of the key executive paying nondeductible premiums. The employer uses the policy cash value as an informal, tax-efficient vehicle to accumulate funds to pay future retirement benefits to the executive.
- On the executive’s retirement, the employer pays the retirement benefit to the retiree, deductible to the employer and taxable to the retiree.
- If the executive dies prior to retirement, the employer may use the generally tax-free income death proceeds to pay survivor benefits to the executive’s named beneficiaries in a lump-sum or as income paid over a stated period of time. Distributions to the beneficiaries are deductible to the employer and taxable to the beneficiaries.
It is never too early to plan ahead. If your company has questions about implementing any of these plans or agreements, FORVIS is here to help.