What is a buy-sell agreement?

A legal contract among co-owners of a business that says what happens to an owner's share if that owner dies, becomes disabled, retires, or leaves. It fixes the price and the buyer in advance so the surviving owners are not negotiating with a grieving family.

Why fund it with life insurance?

Death is the most common triggering event and the hardest to fund from cash flow. A policy on each owner puts the money in the right hands at the moment it is needed, tax-free, no lender required.

Cross-purchase vs entity redemption, what is the difference?

In a cross-purchase, each owner personally buys a policy on every other owner. In an entity redemption, the business buys one policy on each owner and the business itself uses the proceeds to buy back the shares.

How many policies are needed?

Cross-purchase needs n times (n minus 1) policies. Two owners need 2 policies. Three owners need 6. Four owners need 12. That is why cross-purchase gets unwieldy fast, and larger groups tend to switch to entity redemption or a trusteed arrangement.

Do we still need this if we have a written agreement?

The agreement without funding is just a promise. When the day comes, the surviving owners have to come up with the cash, often from their own pockets or from a bank loan. Funding turns the promise into a workable plan.

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Funding a buy-sell agreement, without wrecking the business

If you own a piece of a business with other people, a buy-sell agreement is one of the most important legal documents you will ever sign. It answers a simple, painful question in advance: what happens to your share of the company if you die, become disabled, get divorced, or want out. Without a buy-sell, your family could end up as unwanted business partners of your co-owners, and your co-owners could end up in court negotiating with your spouse.

Why life insurance is the standard funding tool

A written buy-sell is a promise. Life insurance turns that promise into cash on the exact day it is needed. When an owner dies, the policy pays the death benefit, typically tax-free, to whoever is set up to buy the shares. That party writes a check to the family in exchange for the deceased owner's interest. The business keeps operating, the family gets fair value, and nobody has to borrow.

Cross-purchase

In a cross-purchase, each owner personally buys a policy on every other owner. When an owner dies, the surviving owners use the proceeds to buy the deceased owner's shares directly. The upside is that the survivors get a stepped-up basis on the shares they buy, which reduces tax on a future sale. The downside is the number of policies. Two owners need 2 policies. Three owners need 6. Four owners need 12. It grows quickly with the formula n times (n minus 1).

Entity redemption

In an entity redemption, the business itself owns one policy on each owner. When an owner dies, the business collects the death benefit and uses it to redeem the shares. This structure needs only n policies and is much simpler administratively. The tradeoff is that the surviving owners do not get a stepped-up basis on the redeemed shares, which can cost them tax later.

Which one is right?

Two owners? Cross-purchase is usually the cleaner answer. Four or more owners? Entity redemption or a trusteed cross-purchase is usually more practical. Three owners is the classic borderline case. The right answer depends on the age spread, tax situation, and legal preferences of the group. An attorney and a tax advisor should sign off.

Size it to actual insurable interest

The policy face on each owner should equal that owner's insurable interest: total business value multiplied by that owner's ownership percentage. Undersize it and the survivors are still short. Oversize it and premium dollars are wasted, and you can create tax and valuation issues. Review the number every few years as the business grows.

Do not stop at the policy

Insurance is only half the job. The buy-sell agreement itself has to be up to date, with a defensible valuation formula or a scheduled appraisal. Many old agreements list a value from a decade ago that has nothing to do with the current business. Revisit the agreement any time the numbers, the owners, or the tax law materially change.