Life Insurance for Buy-Sell Agreements
A buy-sell agreement can establish what happens to an owner's interest when they die. The life insurance funding needs to provide the money to help make that plan work.
The right coverage starts with understanding the ownership, the obligation created by the agreement, and who will need the money—not simply choosing a policy amount.
A Buy-Sell Agreement Doesn't Create the Money
A buy-sell agreement can establish what happens when an owner dies, but that is only part of the planning. There also needs to be a practical way to fund the ownership transfer.
| THE AGREEMENT
Defines what should happen
Establishes who is expected to purchase the ownership interest and how the transfer is supposed to work.
| THE OBLIGATION
Determines what needs to be funded
The value of the ownership interest and terms of the agreement help determine how much money needs to be available to complete the purchase.
| THE FUNDING
Provides the money
Life insurance can provide money at an owner's death so the business or surviving owners don't have to rely entirely on cash, borrowing, or other assets to fund the purchase.
The goal isn't simply to have a buy-sell agreement and some life insurance.
The agreement, ownership structure and funding need to work together.
Start With What Needs to Happen to the Ownership
Before deciding how much life insurance to buy, start with the ownership interest itself.
When an owner dies, does the agreement require the business to purchase their interest? Are the surviving owners supposed to purchase it? What is that interest worth, and how is that value determined?
Those answers define the obligation we're trying to fund.
Life insurance comes after that. Once we understand who is buying the ownership interest, what needs to be purchased and approximately how much money will be required, we can begin designing coverage around the actual need.
Don't start with,
"How much life insurance
should we buy?”
Start with:
“What needs to happen
to this ownership interest
when one of us dies?”
The insurance should be designed
around the answer.
Who Owns the Insurance Changes How the Plan Works
Once you know what needs to happen to the ownership interest, the next question is who will be responsible for purchasing it. Two common approaches are a cross-purchase arrangement, where the other owners purchase the interest, and an entity-purchase or redemption arrangement, where the business purchases it. That distinction matters because it affects who owns the life insurance, who receives the proceeds and how the money ultimately gets where it needs to go.
The Other Owners Purchase the Interest
In a cross-purchase arrangement, the business owners generally own life insurance on one another. When an owner dies, the surviving owner or owners receive the insurance proceeds and use the money to purchase the deceased owner's interest according to the agreement.
This can be relatively straightforward with two owners, but the insurance structure can become more complicated as the number of owners increases.
The Business Purchases the Interest
In an entity-purchase arrangement, the business generally owns life insurance on the owners. When an owner dies, the business receives the insurance proceeds and uses the money to purchase, or redeem, the deceased owner's interest according to the agreement.
This can simplify the number of policies needed when there are multiple owners, but ownership, tax and valuation considerations can make the structure itself important.
There isn't one structure that's right for every business.
The agreement, ownership, number of owners, tax considerations and practical administration all matter. The attorney, CPA and insurance professional each have a role in making sure the pieces of the plan work together.
The Coverage Has to Match the Obligation
Once you've determined who will purchase an owner's interest, the next question is how much money needs to be available to complete that purchase. That starts with the value of the business and the value of each owner's interest.
A business worth $5 million with two 50% owners creates a very different funding need than the same business with owners holding 60%, 30% and 10%. The death benefit shouldn't simply be a convenient round number—it should be designed around the obligation the buy-sell agreement is intended to fund.
The business valuation also needs to be meaningful. Some agreements establish a valuation method, formula or process for determining the purchase price. Whatever method is being used, the insurance funding needs to be coordinated with it.
The death benefit should trace back to the value being purchased and the terms of the agreement.
Business Value
What is the business worth?
Ownership Interest
What portion of that value belongs to this owner?
Buyout Obligation
What does the agreement require to be purchased?
Insurance Funding
How much death benefit should be available to help fund it?
$5,000,000 business value
× 40% ownership interest
= $2,000,000 ownership value
But that doesn't automatically mean the right answer is a $2 million policy. The agreement, valuation method, ownership structure, existing insurance and other financial obligations still need to be considered when determining the appropriate coverage.
And the work isn't necessarily finished when the policies are issued.
Businesses grow, ownership changes and valuations change. A buy-sell agreement funded appropriately today can become underfunded—or occasionally overfunded—if the agreement and insurance aren't reviewed as the business changes.
One Business. Two Buy-Sell Structures.
Two business partners were purchasing a manufacturing company while one of the existing owners retained a minority interest. That meant we couldn't treat all three owners the same when it came to the buy-sell planning.
The two new majority owners used a cross-purchase arrangement between themselves. The remaining minority interest was handled differently, with the business responsible for purchasing that owner's interest.
So instead of simply putting the same amount of life insurance on everyone, we matched the coverage to the ownership interest being purchased and who would be responsible for buying it.
Certain details and amounts have been changed to protect client confidentiality.
$8 Million
~45% Owner
~$3.6M coverage
~45% Owner
~$3.6M coverage
Each majority owner owned life insurance on the other to help fund the purchase of that owner's interest.
~10% Owner
~$800K coverage
The business owned the life insurance intended to help fund the purchase of the remaining minority interest.
The coverage followed the ownership obligation.
Same company. Different ownership interests. Different funding structures.
Questions About Buy-Sell Life Insurance
Can I use life insurance I already have to fund a buy-sell agreement?
Sometimes.
Existing life insurance may be able to help fund a buy-sell agreement, but we first need to look at who owns the policy, who the beneficiary is, how much coverage is available, how long the coverage is expected to last, and what the policy is already intended to protect.
For example, if you bought a policy to protect your family, using that same coverage for a business buyout could leave your family with less protection than you intended. In other situations, we may be able to use some existing coverage and add new coverage only where it's needed.
The goal isn't to automatically buy another policy. It's to make sure the coverage you have fits the obligation you're trying to fund.
Should we use term or permanent life insurance for a buy-sell agreement?
Either can work. The right choice depends on how long the buy-sell obligation is expected to exist and what the business owners are trying to accomplish.
Term insurance can make sense when the need is temporary or when keeping the initial cost lower is important. Permanent life insurance may make more sense when the buy-sell obligation is expected to continue for many years and the owners want coverage designed to remain in place long term.
Sometimes the answer isn't simply one or the other. The coverage can also be structured using more than one policy or type of insurance when that better fits the business and the obligation being funded.
What happens if one of the owners can't qualify for life insurance?
It doesn't necessarily mean the buy-sell plan can't work, but it may change how the agreement is funded.
Health history can affect whether coverage is available, how much can be purchased, and what it costs. Depending on the situation, we may look at different insurance companies, different policy designs, or whether only part of the obligation should be funded with life insurance.
This is also one reason I prefer looking at the insurance side while the buy-sell agreement is being developed rather than waiting until everything else is finished. You don't want to build a plan around life insurance and then discover that one of the owners can't get the coverage the plan was expecting.
What if our business has more than two owners?
Buy-sell life insurance can still work with multiple owners, but the ownership and funding structure can become more complicated.
With a cross-purchase arrangement, each owner may need to own coverage on the other owners. As more owners are added, that can mean more policies to manage. An entity-purchase arrangement may simplify the insurance because the business owns the policies instead, but that doesn't automatically make it the better choice.
The right structure depends on the number of owners, their ownership percentages, the buy-sell agreement, and the legal and tax considerations involved. This is where coordinating the insurance with the attorney and CPA becomes especially important.
Is buy-sell life insurance the same as key person life insurance?
No. They can use the same type of life insurance, but they're designed to solve different problems.
Buy-sell life insurance is intended to provide money to help purchase an owner's interest when they die. Key person life insurance is intended to help protect the business from the financial impact of losing someone who is important to its success.
A business may need one, the other, or both. The important part is knowing what each policy is supposed to accomplish so the coverage isn't being counted on to solve two different problems at the same time.
What happens if an owner becomes disabled instead of dying?
Life insurance generally isn't designed to fund a buyout triggered by disability, so that risk needs to be planned for separately.
Some life insurance policies include living benefits that may allow the insured to access a portion of the death benefit after certain qualifying illnesses or medical events. Those benefits can be valuable, but they aren't the same as disability buy-out insurance and shouldn't automatically be counted on to fund the purchase of a disabled owner's business interest.
A buy-sell agreement may address both death and disability, but the funding needs are different. If disability is one of the events covered by the agreement, we should look at how that obligation would actually be funded rather than assuming the life insurance will take care of it.
Kevin Woolley
Founder | Woolley & Woolley Insurance Group
Ready to Make Sure Your Agreement and Your Insurance Work Together?
A buy-sell agreement can spell out what should happen when an owner dies. The life insurance needs to provide the money to help make that plan work.
Whether you're putting a new agreement together or reviewing one that's already in place, I can help you look at the ownership, the coverage, and how the pieces fit together.