Using Life Insurance to Fund Buy-Sell Agreements
A buy-sell agreement is a legally binding contract that outlines how business ownership is transferred upon a triggering event, such as the death, disability, or retirement of a shareholder. Life insurance provides critical funding for these agreements, ensuring that the remaining owners have the liquidity to purchase the departing owner’s interest.
Types of Buy-Sell Agreements
- Cross-Purchase Agreement
- Each shareholder owns a life insurance policy on the other shareholders.
- If a shareholder dies, the surviving shareholders receive the policy’s death benefit and use it to buy the deceased shareholder’s stake.
- Entity-Purchase Agreement (Stock Redemption)
- The business itself purchases life insurance policies on each shareholder.
- If a shareholder dies, the business uses the policy proceeds to buy back (redeem) the deceased shareholder’s interest.
- Hybrid Agreement
- Combines elements of both cross-purchase and entity-purchase arrangements.
- Often used when the optimal structure may depend on varying circumstances, such as ownership changes or tax considerations.
Tax Implications for Buy-Sell Agreements
- Death Benefits
As noted above, life insurance proceeds are generally free from federal income tax, whether paid to the business or individual shareholders. - Premiums
Although critical for funding buy-sell agreements, premiums paid are not tax-deductible. They represent a cost of ensuring business continuity. - Basis Adjustments
In cross-purchase agreements, surviving shareholders often receive a step-up in basis on the purchased shares, potentially reducing future capital gains tax if they eventually sell their interests. - Corporate AMT (Alternative Minimum Tax)
Under prior law, C corporations sometimes had to consider life insurance proceeds when calculating their AMT liability. However, the Tax Cuts and Jobs Act of 2017 effectively repealed the corporate AMT, eliminating this concern in most cases.
Shareholder Exits: Process and Life Insurance’s Role
- Establishing the Buy-Sell Agreement
- Shareholders agree on a valuation method for the business and draft the buy-sell contract.
- Life insurance policies are purchased with beneficiaries designated according to the type of agreement (cross-purchase or entity-purchase).
- Event Trigger
- A trigger, such as the death, disability, or retirement of a shareholder, activates the terms of the buy-sell agreement.
- Death Benefit Liquidity
- The insurer pays the death benefit to the designated beneficiary (the business or remaining shareholders).
- Execution of the Buyout
- In a cross-purchase arrangement, surviving owners use the proceeds to acquire the departed owner’s shares.
- In an entity-purchase arrangement, the company redeems the shares from the estate or the departing shareholder, consolidating ownership.
- Share Redistribution
- The purchased or redeemed shares are reallocated among surviving or remaining shareholders.
- This process helps preserve the continuity and operational stability of the business.
Example
Consider a company with three equal shareholders: A, B, and C. They establish a cross-purchase buy-sell agreement and each buys a $1 million life insurance policy on the others.
- Scenario: Shareholder A passes away.
- Outcome: The policies on A’s life pay $1 million each to B and C.
- Execution: B and C use the $2 million in proceeds to purchase A’s shares from A’s estate.
- Result: B and C each own 50% of the business, and A’s estate receives fair compensation for A’s stake.
Conclusion
Life insurance is a pivotal component in buy-sell agreements, offering tax-free liquidity and ensuring that ownership transitions occur smoothly. By understanding the relevant tax rules and structuring these agreements appropriately, businesses can protect both their continuity and the financial interests of all stakeholders.
References
- Internal Revenue Code:
- IRC §264(a)
- IRC §101(a)
- IRC §101(j)
- Tax Cuts and Jobs Act of 2017
- IRS Publication 525: Taxable and Nontaxable Income
This article is intended for informational purposes only and should not be construed as tax or legal advice. Consult a qualified professional for guidance specific to your situation.