A Buy-Sell Arrangement That Benefits the Living and the Dead

It’s a fact: Most business owners will execute a living buyout rather than have a business owner die prematurely. That fact makes it critical to have a buy-sell agreement to protect from a premature death while simultaneously positioning the business owner for their eventual retirement.

In one of our industry’s more delicious ironies, the type of life insurance typically used to fund Buy-Sell Agreements (BSAs), term insurance, is probably the least appropriate funding solution. The truth is that a permanent solution, with properly structured ownership, places a powerful financial planning tool in the hands of each business owner. A permanent life insurance solution can fund their BSA and provide supplemental, tax-favored retirement income, long-term care benefits, and more.

Trends Affecting the Use of Buy-Sell Agreements

A significant influence is the perceived lack of control in most cases stemming from either another owner or the business itself controlling the policy. In most instances, this can be traced back to a knowledge gap relative to the types of agreements beyond those two basic structures. Fortunately, in this particular instance, the solution not only addresses the fundamental issue outlined above, but it does so without increasing the complexity of the agreement to the point it becomes unwieldy, if not prohibitive, to administer.

If step one in designing a more effective BSA is simply moving from term insurance to permanent, the next step is addressing ownership. In too many cases, the simplicity and ease of implementing a stock redemption plan, with the business owning the policies, receiving any death proceeds, and “redeeming” the deceased owner's shares, is too tempting. This eliminates the possibility of significant tax savings for the surviving owner, a topic for another discussion, and still places the business owner at a disadvantage relative to controlling all of their insurance assets as the company remains the owner and beneficiary of the surviving owner’s policy. 

While more advantageous from a tax perspective, traditional cross-purchase designs still present the issue of lack of control: The other owner owns the insurance! While these two approaches can accomplish the ultimate goal of providing funding for the BSA when needed, they are far from being an optimized solution.

If Both Types of BSA Are Less Than Ideal, What’s the Answer?

While each planning scenario is different and should be evaluated on its own merit, the “cross endorsement” structure checks most of the boxes discussed here:

• Each business owner is the owner of the policy on their own life.
• As a result, they control the death benefit, cash value, and any living benefits the BSA policy may provide.
• A simple assignment form secures the portion of the death proceeds needed to buy out the other business owner at their death.

More importantly, this also allows each owner to make full use of the policy as part of their retirement, long-term care, and perhaps even estate planning if they, like most business owners, execute a living buyout. Finally, at retirement, this happens without some sort of taxable event or an esoteric exemption to the transfer for value rules most do not understand, let alone plan for effectively.

The flow chart below shows the basic mechanics of this approach regarding the flow of funds if one of the owners passes away. What it doesn’t do is address how each owner can make the “highest and best use” of their policy. To do that, moving the owner beyond viewing this premium associated with their BSA funding strategy as an expense to something that creates an asset on their personal balance sheet is critical. That effectively eliminates term insurance from the conversation. 

The key subject matter areas to discuss with the owner as they consider how to structure their funding strategy with permanent insurance include:

• Their protection needs beyond the BSA. Specifically, is their personal insurance adequate? If not, simply increase the policy coverage to cover both business and individual needs.
• Have they planned for the potential need for care as they age? If not, consider using a Chronic Illness or Long-Term Care Rider on the policy.
• Is their retirement plan adequately funded? If not, consider a BSA policy designed to accumulate cash value while providing a death benefit. This could also solve challenges like limitations on qualified plan contributions.

The Upsides of Flexibility and Ample Planning

The 'cross endorsement' structure allows each owner to design their own strategy based on their unique needs. This level of personalization ensures that the structure caters to the individual circumstances of each business owner, making it a highly adaptable and effective solution.

As simple as this strategy is, there are some places where business owners may try to cut corners. Specifically, this arrangement does not eliminate the need for a formal, written BSA. Further, the BSA needs to be reviewed regularly, including updating the value of the business. If they want to pay for the coverage through the business, as most business owners do, there will likely be personal income taxes due on those funds, which will likely be treated as compensation. There may also be tax due on the economic value of the assigned coverage. These issues make the Business Owner’s CPA or other tax expert critical to the conversation.

There are additional benefits to the cross endorsement or “Living Benefits” buy-sell agreement, including:

• Personal ownership of your policy: the business owner names the primary beneficiary and controls the cash value. Any death benefit not committed to the buy-sell agreement can go to family or other personal beneficiaries.
• Younger and healthier owners aren’t required to pay premiums on older and less healthy business partners as they might be with a cross-purchase buy-sell agreement.
• You can fund your own policy at a higher level to build greater cash value for your future use.
• The policy is portable — if the business ends or you retire, you retain the policy and any cash value.
• As an individually owned BSA policy, it may be protected against business creditors depending upon the laws of your state.

The bottom line? There is far more utility from a cross endorsement BSA funded with permanent insurance than from other agreement types or agreements funded with term insurance. We would all benefit from considering the rest of the business owners planning versus pursuing the path of least resistance.

Agents and advisors looking to support their clients with smart, long-term buy-sell planning don’t have to navigate it alone. LIFE Brokerage partners with you to simplify complex structures and provide custom product recommendations. If you’re ready to elevate your service and give your clients solutions that protect business continuity as well as future financial security, reach out to LIFE Brokerage today.