The loss of critical personnel can be life threatening to small businesses; however, it is a risk that life insurance often can mitigate. Life insurance policies are frequently used in plans aimed at making it possible for a business to survive a change of ownership or the loss of a chief executive, partner, or other person whose talent drives the operation.
Typically, the insurance funds a buy-sell agreement that provides for the orderly transfer of ownership interests and compensates for the loss of a key person.
A buy-sell agreement allows the remaining owners to acquire the interest of a withdrawing owner due to death or another specified event, such as disability or retirement. The agreement typically restricts the owner’s ability to transfer his or her interest and sets out the terms under which another owner may acquire the departing owner’s interest.
A buy-sell agreement can anticipate situations that could imperil the business or be harmful to owners and employees. For example, it can prevent unwanted outsiders or heirs from obtaining an ownership interest, or it can ensure the legal continuation of the entity should the owner lose a required professional license.
Among its benefits, the buy-sell agreement creates a marketplace for the shares of a closely held business, helping ensure that departing owners will receive adequate compensation. How life insurance is employed depends on the structure of the buy-sell agreement. With a partnership, the agreement may call for each partner to maintain policies on each of the other partners in an amount sufficient to cover a beneficiary’s partnership interest. In other types of buy-sell plans, the business entity purchases the insurance policy on each owner and the business is the beneficiary.
When considering use of life insurance to fund a buy-sell agreement, be aware of the following:
- Establishing a value (or valuation method) for the business is a necessary step in determining how much funding will be needed for a buy-sell agreement. Likewise, the amount of life insurance to purchase for a key person should be based on a reasonable assessment of the costs the firm would incur if the person were to leave.
- A professional appraisal usually is advisable when preparing a buy-sell agreement.
- Your insurance agent can provide information about life insurance terms and costs.
- Business owners should consult legal and tax advisors to discuss how a proposed buy-sell agreement may affect their personal financial situation and estate planning.
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