In a small to medium-sized business, the death
of a partner or key officer/shareholder reduces the value of its
business assets (as well as legally terminates a partnership).
In order to preserve the partnership assets, the survivors must
liquidate the partnership with care. The partnership's reformation
must deal with different needs. Typically, the surviving partners
wish to continue the business without the deceased partner's heirs.
The deceased partner's family is most concerned with income replacement.
The death of a stockholder in a small, closely held corporation
also creates a substantial risk of business failure. At best,
the corporation may face a serious loss of business, reduction
in asset values and the loss of jobs.
All of the above consequences may be avoided with a carefully
planned buy-sell agreement.
A popular method of keeping a business in operation
after the death of a partner or a major officer/shareholder is
the use of the Buy-Sell Agreement (also known as a Business Continuation
Agreement).
A typical buy-sell agreement between the partners allows the surviving
partner to purchase the interest of the deceased in order to keep
the business operating and keep it out of the deceased's estate
and probate. A buy-sell agreement stipulates that if one partner
dies, the other partner will have the right to purchase the deceased
partner's share of the business at a predetermined price or according
to a specified formula.
In a small business where money is often tight, finance is the
critical piece of the buy-sell scenario. The purchase of a life
insurance policy is an ideal way to fund the agreement.
For purposes of illustration, let's assume that we have two partners
who formulate a buy-sell agreement. In the formulation of the
policy, they agree that each will take out a $100,000 policy on
the other. Their small corporation purchases the life insurance.
Upon the death of one, the other will have the money to pay to
buy out half of the business.
If the two partners were to personally purchase the life insurance on the other, the arrangement would be referred to as a Cross-Purchase Plan. Let's assume for a minute that we have multiple partners. If we have six partners and try to do a cross-purchase plan, then each partner would own 5 policies on the other partners for 30 total policies. While this may be a life insurance salesperson's dream, it certainly isn't a practical arrangement. In this situation, we would be more likely to use the entity agreement. In an entity agreement, the partnership owns life insurance on each partner, and the partnership agrees to purchase the share of the business that belonged to the now deceased partner. This requires 6 policies rather than 30.
While the life insurance premiums are not tax
deductible, the proceeds are not subject to federal income tax.
Further, a funded buy-sell agreement offers other advantages,
including:
It's extremely important to involve both an attorney and an accountant
when arranging a buy-sell agreement since the written terms vary
with the structure of the business.
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