How a Buy/Sell Agreement Funded By Life Insurance Is An Effective Business Succession Planning Tool

An estate lawyer will tell you how important it is to have a will. And they are absolutely right. A business lawyer though will tell you how important it is to have a shareholders agreement when you own a business with partners. And they are also absolutely right.

A shareholders agreement is exactly as it sounds. An agreement amongst shareholders and deals with a number of different topics. It is sometimes awkward to talk about when setting up, and you hope that you never need to actually enforce its provisions, but a well drafted agreement is invaluable when you need it. Think of it as like a prenup or a marriage contract. Prior to getting married, two people want to spell out the ‘terms’ of their marriage and what happens if it breaks down. You hope you never need to actually use it, but life happens. A shareholders agreement is similar. An important aspect of a shareholders agreement is how to deal with the death, bankruptcy, or marriage breakdown of a shareholder part of the agreement.

For example, if you own part of a business with three other partners (each of you own 25% each) and you were to kick the can tomorrow, what would happen to your shares of the business? Assuming you have a will and left all of your assets to your spouse, the spouse would become the owner of the shares. This could create two potential problems. The first problem is if you have a capital gain on your shares. You are deemed to dispose of your shares on the date of your death, so if you have a large capital gain, your estate will have a corresponding large tax bill on your final tax return. Your spouse will be left with figuring out how to pay this tax bill. Secondly, your spouse may have a desire to get involved with the business, make changes, etc. Chances are your three other partners aren’t overly excited about this idea.

Enter the Buy/Sell provisions of your shareholders agreement that you had hoped you’ve never have to refer to. Basically the provision will say something along the lines of “if a particular event occurs to a shareholder (i.e. death), the remaining shareholders/corporation will purchase/redeem the shares of the departing shareholder at some pre-established value (e.g. fair market value)”. The challenge then becomes how to finance the purchase/redemption of these shares. If the business is worth $4 million ($1 million per shareholder), then the three remaining shareholders each need to come up with $333,334 to buy the shares from the estate of the late fourth shareholder. This could be difficult.

The easiest and most efficient way to deal with a situation like this is through life insurance. In essence, life insurance would be taken out on the life of each shareholder in the amount approximate to the value of their shares (in the case above, each shareholder would have a $1 million policy). There are generally three ways to structure the life insurance and each way is discussed below.

Criss-Cross Method

Using this method, each shareholder would purchase a life insurance policy on the life of all the other shareholders and names themselves as the beneficiary. Continuing with the example above, assume the shareholders of Acme Company are Adam, Bob, Chris and Dan. Adam will purchase an insurance policy on the lives of Bob, Chris and Dan each for the amount of $333,334. Bob will do the same on the lives of Adam, Chris and Dan, etc. If Dan were to pass away, Adam, Bob and Chris would each receive $333,334 tax free which would then be used to purchase Dan’s shares from his estate for $1 million.

Promissory Note Method

Under this method, Acme Company would take out an insurance policy on the life of each shareholder for $1 million. Upon death of one shareholder, Acme Company would receive a death benefit of $1 million tax free. Then, pursuant to the Buy/Sell agreement, each shareholder would agree to purchase 1/3 of the shares owned by the departed shareholder. Instead of paying cash for the shares, each remaining shareholder will issue the estate of the departed shareholder a promissory note for the purchase equal to $333,334.

Following the purchase, Acme Company is required by the Buy/Sell agreement to pay out the life insurance proceeds to the surviving shareholders as a tax-free dividend (life insurance proceeds received by a corporation, if structured properly, go into something called a Capital Dividend Account. This allows the corporation to pay out the proceeds as a dividend, tax free to the shareholders). Each surviving shareholder would then repay the promissory note of $333,334 owing to the estate of the departed shareholder.

Corporate Redemption Method

With the corporate redemption method, Acme Company would be the owner and beneficiary of a life insurance policy on the life of each shareholder for $1 million. Upon the death of one of the shareholders, Acme Company would receive a death benefit of $1 million tax free (as discussed in the Promissory Note Method above, it would go into the Capital Dividend Account). These funds would then be used to purchase and cancel, or redeem the shares of the departed shareholder’s estate.

Summary

Each method has its various pros and cons and it really depends on the facts and circumstances of each situation to determine which is best. Some factors that need to be considered are:

• whether it is better for the corporation or the individual to own the insurance
• the premiums for the life insurance is not tax deductible
• family law considerations (depending on who receives the death benefit, the proceeds could be either included or excluded from the beneficiary’s net family property)
• Annual administration of the policies (becomes more difficult if the policies are owned individually and with more shareholders)

Hopefully the above information provided you with a basic understanding of how a Buy/Sell Agreement and life insurance works. If structured properly, this can be a very efficient and effective business succession planning tool for you and your business partners. Don’t be fooled though. It is a complex issue and is something that you should get your lawyer and/or accountant involved with to ensure it is structured properly. If this is an area where you would like to learn more about, feel free to contact us.