There are many options to fund a buy-sell agreement, some methods more successful than others.
You could fund buying and selling with cash. To accommodate this, you would need to have and hold cash reserves. However, most business’s capital isn’t sitting in a cash account. It’s usually tied up in illiquid assets or inventory. That means if you opt to use cash, you may end up having to sell off inventories or ending up short.
Another funding option is a sinking fund. This allows you to set aside reserves a little at a time. However, since you can’t predict the timing of premature death or disability, a sinking fund may not have had time to mature.
You could decide to use a loan. The remaining business owners would need to qualify for and obtain financing. The difficulty here lies in the fact that creditworthiness may have suffered due to the triggering event itself and the perceived instability and uncertainty of the company. Additionally, this adds interest to the buyout cost.
Another method of funding the buyout could be installment payments to the heirs. This is similar to seller financing. The seller, in this case, the departing owner’s estate, receives an ongoing stream of cash flow rather than a lump sum all at once. But the company may not be in a position to make guarantees of future payments. If the company itself suffers, payments may dry up.
Finally, life insurance policies provide the most guarantees and certainty as a financing option. A death benefit equal to the market value of the company guarantees that at the triggering event, sufficient funds will be in place to execute the buyout. Whether you’ve paid premiums for 15 years or only 1 month, the full death benefit will payout. That’s why it is the most economical option to fund buying and selling agreements.
Additionally, disability insurance can also be used to buy out the company in the case of disability.
Your buyout agreement can be funded in several ways. Here are the there main types:
In a stock redemption buy-sell agreement, the company purchases insurance policies on the owners. Upon the death of an owner, their death benefit pays out to the company. The company can then exchange the proceeds with the departing owner’s estate for that owner’s stake in the compnay. The company ends up with the stock, and the estate ends up with the cash. The remaining business owners now own 100%.
Here are the pros and cons. You would need only one policy per co-owner. However, the surviving co-owners wouldn’t receive a step-up in basis. That means they’d pay capital gains tax on the portion of the business they received from their partner if they later went on to sell.
A second way to set up a buy-sell agreement with insurance is a cross-purchase. Here, each co-owner purchases policies on the others. For example, Tom and Chris buy policies on each other. In the event of Tom’s death, Tom’s policy pays out to Chris, who is the owner and beneficiary of the policy. Chris uses the cash to buy out Tom’s shares. Again, both parties are made whole.
The cross-purchase buy-sell agreement allows the recipient of the company shares to get a step-up in basis. The downside to this arrangement is that it can get a little bulky and cumbersome. Because each co-owner buys insurance on each of the other co-owners, if there are three or more co-owners, multiple policies are needed on each person.
The LLC buy-sell is a third option that facilitates a more straightforward transfer when there are three or more owners. With this model, a new LLC that mirrors the same ownership interests of the original business entity would purchase a policy on each owner.
Here, each person gets a step-up in basis, and only one policy is needed for each owner. Additionally, policies could change ownership without triggering a taxable event. However, you would add in the administration of maintaining a new entity.
Here are a few questions you can use to start thinking through your needs for buy-sell planning:
Once you’ve determined the need for a buy-sell agreement, the next step is to do a professional business valuation. This will determine the current value of each partner’s share of the ownership. That value of the business will then be the baseline for how much funding is needed to substantiate your buyout agreement.
Because insurance is multifunctional, the policies used for your buy-sell agreement could also accomplish other goals.
If you wanted to retire or leave at will, the policy ownership could be transferred to you as a part of the purchase price. You could then access the cash values through income-tax-free loans and withdrawals.
Perhaps one of your co-owners (or all of them) also plays a vital role in the company. You could use the same company-owned policy as a Key Man Life Insurance Policy and the funding for your buy-sell agreement all in one. If the need arose, the insurance proceeds would cover the business’ need to fill the role. At the same time, it would also accommodate buying back the stock ownership from their estate.
Additionally, a policy set up as an Executive Bonus Plan could then be used in a one-way buy-sell agreement where the key employee buys out the existing owner.
A buy-sell agreement isn’t a set-it-and-forget-it plan. It’s an adaptable arrangement that should be just as alive as your company. Once you have your buy-sell agreement in place it is important to revisit the funding level periodically to increase funding over time to keep pace with a growing company.
Depending on the circumstances, insurance may be one part of the funding source that you supplement with other financing.
Also, while you can certainly use term insurance, its payout is limited to the timeframe of the policy. For example, after the ten years of a 10-year term policy, you’d need to set up another insurance policy or establish another funding source.
A whole life policy is best because of the guarantees and predictable cash accumulation.
An additional strength of a Buyout Agreement is that it can also be used for Infinite Banking in your business.
If you use a Specially Designed Whole Life Policy, the policy owner will have a store of capital because of the guaranteed cash value. Depending on how you’ve set up the buy-sell agreement, this could provide either the owners or the company itself with access to a substantial reserve account.
And the unique leverage point of a Privatized Banking system is its uninterrupted compounding. Your money continues to grow and compound inside the Privatized Banking system, even while you use the capital somewhere else. That’s because Privatized Banking is a platform to earn returns in two places at the same time. That means your money goes further and does more.
I hope we’ve opened a door for planning and potential exit strategies that leaves you feeling empowered with one less question mark.
The one thing that is most important to take away from this conversation is the need for planning ahead. If you want to ensure the continuity of your business, a buy-sell agreement funded with insurance may be your ideal solution.
To start the conversation and find out what’s possible, book a call with our advisor team. We’ll help you navigate your exit strategy and continuation needs. You’ll also get the one next thing you need to do on your path to accelerate time and money freedom.
Rachel Marshall is a devoted wife and nurturing mother to three wonderful children. Rachel is a speaker, coach, and the author of Seven Generations Legacy™, passionate about helping enterprising families unlock their true potential and live into the multi-generational legacy they are destined for. After a near-death experience, she developed a deep understanding of the significance of recognizing and embracing one's unique legacy As Co-Founder and Chief Financial Educator of The Money Advantage, Rachel Marshall is renowned for her ability to make money simple, fun, and doable. She empowers her clients to build sustainable multi-generational wealth and create a legacy that extends far beyond mere financial success. Rachel's expertise lies in helping wealth creators remove the fear of money ruining their children, give instructions for stewarding family money, teach financial stewardship and create perpetual wealth through family banking, and save time coordinating family finances. Rachel co-hosts The Money Advantage podcast, a highly popular show that delves into business and personal finance, including how to effectively manage finances, protect wealth, and generate sustainable cash flow. Rachel's engaging teaching style and practical advice have made her a trusted source of financial wisdom for her listeners.
