Life Insurance Premiums in a Buy-Sell Agreement

What is a Buy-Sell Agreement?

Buy-sell agreements are related to business succession planning, which is the process of assuring the continued success of a business as it moves from one generation to the next. Business owners want an assurance that their businesses will survive them, and for many business owners, buy-sell agreements provide that assurance. A buy-sell agreement is a stockholder agreement that deals with the transfer of ownership upon the death, disability, or retirement of one of the owners. For instance, if you are a 50-50 owner of an organization with another 50-50 owner, how do you plan for your death or disability? If you do not have a buy-sell agreement in place, the answer is you cannot arrange for the smooth transition of the business.
A buy-sell agreement is a contract among the stockholders of a corporation setting forth the terms upon which they will sell their shares or the company will acquire its own shares , such as in the event of an owner’s death, disability, or retirement. The agreement is a binding obligation of the business that protects both the stockholders and the organization. Any business with more than one owner should consider such an agreement. While there are many different types of buy-sell agreements, the most common are the corporate stock redemption agreement, the cross purchase agreement, and the one-way agreement.
Commonly used to fund buy-sell agreements is insurance, usually on the life of the shareholder or a key person. This funding provides the company and the stockholders with needed cash to purchase the shares at the time of the triggering event.

The Importance of Life Insurance in a Buy-Sell Agreement

Life insurance serves an important role in a buy-sell agreement. Without insurance, the buy-sell agreement might be subject to the claims of the business creditor of the deceased owner or to the claims of that owners’ spouse upon the death of the owner. In the absence of the type of planning embodied in a buy-sell agreement, the death of an owner of the business could very well destroy the business through litigation over ownership by the children of the deceased owner. Furthermore, the business could not afford the business interest owned by the deceased owner, at least not until time was consumed in litigating over the value of that business interest and with tax consequences that could destroy the business in the meantime.
As a response to this problem, life insurance has been used in the buy-sell area as a funding mechanism for one or more of several different types of buy-sell agreements. Company sponsored term life insurance is often used in cross purchase buy-sell agreements (i.e. where the owners individually agree that, upon the death of one or more of the owners, the remaining owners will purchase the deceased owner’s business interest). The insurance is purchased by the company and owned either by the company or the individual owners, with rights of first refusal in the event of a death; in any case, the business owns the right to call (or buy) the policy. The agreement provides that the death benefit is payable to the business. Proceeds are used to purchase the deceased owner’s business interest from his estate. With this type of plan, the annual premium for the insurance can be paid by the business, not the individual or the company owners, as a deductible business expense.
Life insurance may be used as a form of funding in other types of buy-sell agreements (such as stock redemption agreements and interest redemption agreements), but this type of insuring could become complicated in the case of an interest redemption agreement (i.e. where the business is being sold to or purchased by the business itself). Even in the case of a stock redemption agreement, a "wait and see" or "concurrent" approach might be chosen to preserve the income tax status of the corporation. In such a case, the corporation may do nothing at the time of execution of the buy-sell agreement. If there is a "redemption event" (i.e. the "event" specified in the buy-sell agreement that will trigger the buy-back of the shares of the deceased shareholder), then the company will redeem the shares. If, however, there is no redemption event, then the buy-sell agreement will be deemed to be a partnership agreement and the provisions executing the buy-back by the remaining shareholders will continue to be considered as an ordinary partnership agreement. This is done to avoid the potential "double taxation" of corporate stock that would occur with a timely notification of the redemption agreement in these circumstances.

Determining Life Insurance Premiums

The cost of a life insurance policy depends on the premium that must be paid. There are three factors that affect the premium of a policy: age, health, and coverage amount.
Age
When the insured reaches maturity, their mortality generally increases. For that reason, the older a person is when purchasing a policy, the higher their premium will be. Typically, relatively small premiums will continue to mature in order to purchase a larger policy when the insured reaches 60 years of age.
Health
Life insurance companies tend to refer to the overall health of a person as the risk of the insured. The overall risk of each person is rated in accordance with their lifestyle. The lifestyle of the insured includes such things as their weight, height, family history, and use of tobacco.
Coverage Amount
The greater the sum of a policy, the higher the premium. Hence, if a policy is purchased for $500,000 as opposed to $200,000, the premium on the $500,000 policy will be greater.

Types of Life Insurance Policies Utilized

The types of life insurance policies used in a buy-sell are generally either term insurance or whole life insurance. Term insurance is normally the preferred method for buying insurance because permanent insurance is much more expensive than term. It should be noted, however, that term insurance is only available for a limited number of years and, therefore, it is very important that the initial planning done at the time the buy-sell is drafted be reviewed periodically so that the appropriate insurance can be in place at the time an event requiring a purchase occurs. Because term insurance premiums increase with age, older owners of a company may be unable to afford term insurance sufficient to fund a buy-sell agreement. If the business cannot afford the insurance, then the buy-sell agreement policy may have to be revised to include an alternative financing method. The policies most commonly used to fund a buy-sell arrangement are whole life insurance policies, but the company may find that it is able to afford the term insurance premium at some point in the future when the existing owner is about 60 years old.
Life insurance policies may be issued on individuals, on key employees, on stockholders or corporate officers. In general, insurance owned by an employer on a key employee whose death will have a detrimental effect on the business is frequently referred to as key man insurance.
If a corporation owns a policy on a stockholder, the corporation will have an insurable interest in the stockholder. If a corporation owns a policy on an officer or key employee, there may be no insurable interest unless there is a cross purchase agreement between the corporation and the insured individual. Every buy-sell agreement should be reviewed and the method of acquisition of the insurance policies discussed carefully with an accountant or a qualified estate planning attorney to determine the most prudent approach.

Tax Implications of Premium Payments

The tax implications of paying life insurance premiums under a buy-sell agreement should be carefully considered before entering into an agreement. These consequences can fall on the business entity, or more likely, the individual payers of policy premiums.
Ordinarily, premiums paid on a life insurance policy, by the insured, are not tax deductible. However, there are exceptions. A premium expense may be deductible if the business is the owner and beneficiary of a policy on its key employee. The deduction is essentially the cost of insuring a key employee on tragedy’s behalf. On the other hand, the premiums are (in most cases) not deductible if the business is the owner or payor of a policy on the life of a partner or shareholder. The partners or shareholders have an insurable interest in the lives of each other or other partners in an ownership interest in the business.
As previously mentioned, while the premiums paid under a buy-sell agreement are generally not deductible if the business makes the payment, they are more often deductible to the individual payers under the agreement fronting the money. Again , there are certain exceptions where premium payments are not deductible such as when the arrangement is subject to constructive ownership rules (imposed by Subchapter J of the Internal Revenue Code) or if the arrangement is a compensatory arrangement based on services rendered. Subchapter J rules are intended to prevent the circumvention of community property income rules in matters pertaining to partnerships. Equity owner-employee arrangements based on services rendered may fall within the exception if the arrangement disproportionately favors the equity owners or seems to be for the benefit of the owners instead of the business. Although the deduction is allowed in most cases, it is important to keep records substantiating the premium payments. Otherwise, the IRS may determine that premium payments were actually made on behalf of the business itself, as opposed to the individual payers. To help alleviate this problem, all premium payments made under a buy-sell agreement should be properly accounted for on the business’ overall records as well as on the purchasers’ books of accounts.
A closing payment made to a beneficiary may be taxed as income. The estate of the deceased shareholder is taxed on the amount recognized at the time of the sale and the purchasing shareholder is taxed on the difference between his or her tax basis and the amount paid. Tax basis may include premiums paid before the agreement was enacted.

In What Manner are Premiums Paid

One of the most important insurance considerations in a buy-sell agreement is how the premiums will be paid. For example, there are situations where an insurance company will not permit a monthly payment and will require quarterly, semi-annual or even annual payments. In those cases, for the first 1 or 2 years of a strong relationship with the insurance company and agent, it may be necessary to either stockpile premiums in a reserve account of the business so that company checks can be drawn from the account when premiums are due, or make arrangements for a corporate credit card so that premiums can be charged by the agent (and the premiums will be paid directly to the insurance company). The latter approach involves little risk to the business because the credit card will be administered by the company. If the agent sells the credit card accounts receivable, they will have only a recourse against him or her and not the business. It is also important to take into consideration how premiums may be structured once the buy-sell agreement becomes effective. For example, a "cross purchase" buy-sell agreement may contemplate a situation where all of the stockholders pay premiums, while a "corporate redemption" buy-sell agreement may contemplate that only those shareholders who are expected to acquire shares in the near future will pay premiums. However, particularly if there is a large age heterogeneity in the business or an ongoing succession plan, premiums should be paid by or on behalf of all shareholders. Otherwise, all of the "non-paying" shareholders could convert to cash payments for their shares, leaving the business with a "gift" to buy out a shareholder at a value that may have been substantially depreciated but whose full value was necessary to pay premiums to maintain coverage for those who did pay premiums.

Life Insurance Problems, and Solutions

Some of the common issues with life insurance in this context include:

Inadequate Coverage Amount. If there is a loss or if a number of losses occur in a short period of time, the coverage may not be adequate. This is particularly a problem for shareholders in a small business where there is little liquidity. Life insurance proceeds are often the only source of funding.
Inadequate Number of Policies. Continuing with the small business example above, if there is only one policy for two or more shareholders, the amount of the insurance will be spent down quickly, leaving insufficient funds for a second or third loss.
Poor Timing. Sometimes, a good amount of time will pass before the insurance proceeds are released. The threshold determination of whether the policy proceeds will be paid out, and the determination of the amount of the proceeds to distribute, can take a long time. Proceeds may be held for up to 6 months, or longer in some cases, while the insurance company investigates.
Wrong Payee. To avoid the wrongful payee problem, it is imperative that the terms of the buy-sell agreement be adequately communicated to the insurer. If one person dies and his or her rights and obligations under the buy-sell agreement are passed on to a spouse, the insurance company must be so advised to avoid the problem of paying out to the wrong payee.
Problems with Tax. In order to avoid significant income tax problems, the beneficiary of the policy should be the buy-sell entity.

There are a number of solutions to these challenges:

Conclusion – Best Practices

To ensure masterful integration of life insurance premiums in the buy/sell context, it is important that all parties coordinate with their legal and insurance professionals. Importantly , each policy acquired should be analyzed to confirm that it best meets the needs of the specific transaction (including a consideration of the age and insurability of the exiting owner), with particular attention being paid to media that is both cost-effective and desirable (individual vs. corporate ownership).