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What To Do If One of the Partners or Owners Is Not Insurable In Your Business Buy-Sell Agreement
Most business advice columns on buy-sell agreements contain an underlying assumption that all of the owners and partners are healthy enough to obtain life insurance or disability income insurance.
The primary reason a business would fund the buy-sell agreement with a life insurance policy on each owner is that the insurance contract shifts the risk to the insurance company. If one or more shareholders dies before the other owners have saved enough money to buy the shares away from the deceased owner’s estate, then the insurance benefits will provide the needed cash.
The same type of risk shifting occurs with the purchase of a disability insurance policy on all the owners, in the event that an owner becomes disabled and the other owners have to buy out her shares. The disability buy-out insurance is a different policy than the disability income insurance that funds the monthly salary for the disabled owner.
But, what do the owners do in the case where insurance cannot be purchased because one of the owners is not insurable?
The dilemma arises because the legal terms and conditions of the buy-sell agreement obligate the other owners to buy the shares, and mandate that the deceased owner’s shares be sold, for an agreed upon price, no matter when the death or disability event occurs.
In the event that there is not insurance in place, then the legal agreement should contain provisions that allow for an installment sale process, where the other owners, in a cross-purchase arrangement, or the company, in the entity arrangement, buy the shares away from the estate over time.
Generally, the agreement would contain the business value, that is updated every year, according to an agreed upon formula.
The agreement would specify the agreed upon initial down payment on the purchase of the shares, and the correct rate of interest to be paid on the remaining balance, for the principal and interest payments, until all the shares have been purchased.
Both of the provisions about down payment and periodic monthly installments must be adjusted to fit the reality and needs of cash flow in the business, or salary needs of the other owners.
Sometimes, the uninsurable owner may have an existing personal policy that can be legally re-titled or modified to suit the purposes of the buy-sell funding requirements. This is not a good solution, because the outside policy probably had some logic or rationale to serve another death benefit need when it was first purchased.
Re-designating the goals and purpose of the outside policy is suboptimal, but is sometimes necessary. Even when an outside existing policy can be found, the death benefit may not be high enough to serve the purposes of the buy-sell business valuation.
If the outside existing life insurance policy is going to be used, then the legal terms and conditions of the buy-sell agreement must contain provisions that allow for a combined installment sale in conjunction with partial insurance death benefit proceeds.
The attorney who prepares the business buy-sell agreement must coordinate the legal agreement with the legal contractual terms of the life insurance policy, including a possible re-titling of the ownership, premium payer and beneficiaries.
This is very complicated and fraught with tax consequences for both the surviving business owners, and the estate of the deceased owner. Both professional legal help, estate help and tax help will be required to assist handling this case. Plus, the types of insurance death benefits options available in the insurance contract will need to be coordinated with the legal agreements.
A slight variation on this idea of using an existing outside insurance policy to fund part of the buy-sell agreement involves the use of an existing term insurance policy, or even the purchase of a new term policy, for a death benefit and premium that covers the risk of a very early death, within the first several years of the buy-sell enactment.
The very early years of the buy-sell are the most risky for all the owners because the company and the owners do not have the financial resources then that they may accumulate in the later years. In other words the gap in funding for the buy-sell agreement from non life insurance coverage is greatest in the early periods.
The insurance underwriting of the term life insurance companies, especially for smaller amounts of death benefit are not quite as restrictive or onerous as for a universal life or whole life insurance policy.
If the term life insurance idea is going to be implemented on the non-insurable owner, then the legal terms of the buy-sell agreement must contain provisions describing how the term insurance death benefits are coordinated with the provisions of the buy-sell agreement.
The buy-sell agreement contains an agreed upon future business value that will be used to assess the dollar value of each owner’s share of the company.
Imagine that the company business value is $300,000 and each of the 3 owners owns 33% of the company.
Assume that one of the three owners can not obtain life insurance.
The total amount of death benefit needed to fund the entire buy-out of the non-insurable owner is $100,000.
The two insurable owners can do two things to help cover the gap in funding on the other owner. First, they can buy and own a type of insurance policy that contains an automatic yearly increase in death benefit on themselves. The automatic increase rider costs a little bit more, but tends to avoid a problem down the road on the funding gap if the company becomes more profitable.
In the example, the current year value of the company is $100,000 for each owner. If one of the insured owners happens to die first, before the non-insured owner, then part of the future funding dilemma can be moderated as a result of the automatic death benefit increase.
Second, the insurable owners can buy a type of life insurance policy that has high rates of internal cash value build up, especially in the early years of the agreement. The internal cash value can be designated to be used to cover part of the funding gap caused by one partner not having an insurance policy.
Sometimes, this idea is called “split-dollar” where parts of the insurance policy are split between different parties.
The attorney who drafts the buy-sell agreement will need to coordinate with the lawyers for the insurance company how the life insurance policies will be titled and owned.
One idea to help solve the funding gap on the non-insurable owner is to begin funding a company investment account where the funds are escrowed and held for the specific purpose of funding the buy-out.
Each month, or periodically, the company would fund the escrow investment account, just like funding insurance premiums. The goal for the company would be to fully fund, or self-insure, the amount required to buy out the non-insurable owner.
The attorney who prepares the buy-sell agreement would insert provisions into the legal agreement on the uses of the escrow funds, tied to the buy-sell agreement.
In an entity arrangement, where the company buys the shares from the estate, this idea is less complicated than when it is combined with a cross-purchase agreement, where the other owners are buying the shares from the estate.
The company would generally open an investment or savings account, titled and owned by the company, and managed by the company. Generally, the company would probably want to obtain outside independent investment advice on the management of the account, to avoid conflict-of-interest or other fiduciary issues.
Most deferred annuities contain payout provisions on the death of the annuity owner. The insurance underwriting requirements of an annuity are not as restrictive as the underwriting for a life insurance policy.
So, in the event that an owner is not insurable for life insurance, that owner may still be able to buy and own a deferred annuity.
The company, or the other owners, would make periodic premium payments to the annuity, just like the case of insurance premiums in a life insurance contract.
The future income benefits and future death benefits of the annuity would match the values of the company in the buy-sell agreement. The future income benefits would match the terms and conditions of the installment sale provisions, and the death benefit would designate the pay out to fund the buy out from the owner’s estate.
The attorney who drafts the buy-sell agreement would need to coordinate the provisions of the agreement with the title and beneficiary of the annuity.
In the case of retirement, instead of death of the uninsured owner, the annuity income payments can be used to fund a living buy-out of the owner’s interest.
Sometimes, the revenues and cash flows of the company are so good that a bank or commercial finance company would consider offering credit or loans to fund the future buy out of the owner’s shares.
Often, the loan could be secured or collateralized with equipment or real estate owned by the company.
It may be a good idea to begin negotiations with asset-based lenders on financing invoices or receivables that could be implemented at the time of death or disability of the non-insured owner. The commercial finance companies require a lead-time to assess the risk associated with a contingent loan to be made in the future.
For commercial banks, the future contingent loan to fund the buy-out may look to the bank like a future line of untapped working capital. As in the case with a commercial finance asset-based lender, the commercial bank will need time to underwrite their risk in offering that future line of credit to fund the buy out.
The bank may be more interested in offering the buy out loan if it is attached to an active line of credit or working capital, so early negotiations would be a good idea.
The attorney preparing the legal buy sell agreement would incorporate provisions regarding the authority of the company to obtain a future loan to fund the buy out and also prepare the board’s resolution to authorize a future contingent loan linked to the buy-sell agreement.
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