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  Business Uses of Life Insurance


What is a buy/sell agreement? What is Keyperson Life Insurance?
How does a buy/sell agreement funded by life insurance work? How do you set up a Keyperson Life Insurance Policy?

What is a buy/sell agreement?

Just consider what might happen to the type of business you have if you would die.

  • Would your sole proprietorship be liquidated?
  • Would your partnership or limited liability company be dissolved?
  • Would corporate shareholders face the financial and legal complexities of buying your shares or facing the unknown of a powerful new shareholder?

You can plan to make your business as stable and well managed as possible through a buy-sell agreement. It makes sense and it's good business

Four sound reasons for a buy-sell agreement
  1. Your business will continue to be managed properly because a buy-sell agreement makes sure your estate sells your business interest to those you choose. There will be no unwanted owners in your business future.
  2. Your estate will have liquidity by converting your business interest to cash. That cash can be used to settle the estate and establish an income stream for your beneficiaries. You'll have an affordable market for your business or stock at a fair, agreeable price.
  3. You'll have a guarantee of a fair, reasonable price for your business. A purchase price will be established among all parties while the business is vital, not when it's vulnerable to a lower price after your death.
  4. You'll have a fair method of arriving at an acknowledged business value for federal estate tax purposes. That's valuation the IRS generally accepts if the agreement is set up properly.

Life insurance provides a simple way to administer a funding vehicle for the purchase of the deceased's ownership according to the terms of the buy/sell agreement. The business also protects itself from any future drain on working capital, damage to its credit position and/or the legal or financial problems that could arise out of the company's inability to fund the buy/sell agreement with its own income.

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How does a buy/sell agreement funded by life insurance work?

Buy/sell agreements may be set up in conjunction with Sole Proprietorships, Partnerships and Corporations. The method for each is a little different. Below you will find a general description of the options available for each type of business.

Sole Proprietorship

If a sole proprietor has a key employee that has the desire to purchase the business in the event of the sole proprietors death, a buy/sell agreement can facilitate the key employee's purchase of the deceased's business. The sole proprietor and the key employee would enter into a buy/sell agreement, and the key employee would purchase a life insurance policy on the life of the sole proprietor. Pursuant to the buy/sell agreement, upon the death of the sole proprietor, the key employee uses the death benefit to purchase the sole proprietors business from his estate.

Partnership

Cross Purchase Plan

In this plan, owners enter into an agreement with one another. To fund this plan, each owner applies for, owns, and pays the life insurance premiums on the other owners.

When an owner dies:

  • Life insurance proceeds are paid to the surviving owner(s) income tax free.
  • Proceeds are used to purchase the heirs' business interest.
  • Heirs receive an agreed-upon payment for their business interest.
  • Surviving owner(s) receive an increased cost basis for the acquired business interest.
Entity Plan In this plan, owners enter into an agreement with the business. The business applies for, owns, and pays the life insurance premiums on each owner.

When an owner dies:
  • The business will receive the life insurance proceeds.
  • The business uses the proceeds to purchase the deceased's business interest.
  • Heirs receive an agreed-upon price for their business interest.
Corporation

Cross Purchase Plan

In this plan, owners enter into an agreement with one another. To fund this plan, each owner applies for, owns, and pays the life insurance premiums on the other owners.

When an owner dies:
  • Life insurance proceeds are paid to the surviving owner(s) income tax free.
  • Proceeds are used to purchase the heirs' business interest.
  • Heirs receive an agreed-upon payment for their business interest.
Surviving owner(s) receive an increased cost basis for the acquired business interest.

Stock Redemption Plan A stock redemption plan is an agreement between the business and its shareholders. The corporation applies for, owns, and pays the life insurance premiums on each shareholder. The Stock Redemption Method of entering into a buy/sell agreement offers the advantage of simplicity over the Cross-Purchase Method if the corporation has more than two shareholders or if there is a likelihood that additional shareholders will join the business later.

When a shareholder dies:

  • The corporation will receive the life insurance proceeds.
  • The corporation will use the proceeds to purchase the shareholder's outstanding stock.
  • Heirs receive an agreed-upon price for the shareholder's outstanding stock.

What is Key Person life Insurance

A good way to ensure that a business will survive if something happens to a top executive is for the firm to consider purchasing life insurance - or "key person insurance" - for its key employees.

Like personal life insurance coverage, key person life insurance pays a benefit to the corporation if that person dies. Businesses typically use the proceeds to make up for lost profits resulting from the key person's death, to hire and train a replacement, and to pay any outstanding debts. While credit insurance and buy-sell agreements frequently help fill this need, key person insurance can be an extra layer of protection.

Here are some questions to ask to determine whether your firm needs key person insurance:

  • Who are the profit makers at the company?
  • Whose death would affect the business's profitability?
  • Which employees does the company depend on for specialized areas such as inventions, research, marketing or sales?
  • Has the company recently invested in equipment or expansion, or taken out substantial loans?

How do you set up a Keyperson Life Insurance Policy?

To determine the amount and type of insurance you will need, first ask yourself what you want to happen to your business if something were to happen to the key person. Will the key person be replaced and the business continue? If you are the only owner, will your beneficiaries sell the business? Or, if there are multiple partners, will it be taken over by the remaining owners?

If the business is to continue, the key man will need to be replaced, and the replacement will need time to get up to speed. The amount of coverage you buy should compensate for both the replacement's salary and the period of lower profits during the transition. You can use annual salary as a means of determining how much coverage should be carried. If you think it might take two years for a successful transition, the policy should be written for double the key person's salary.

Once the death benefit amount has been determined, the business would purchase the policy on the key person. The key person would be the insured and the business would be the owner, payor and beneficiary of the policy. Permanent or term life insurance can be used as a key person policy depending on the needs of the business and how much they are willing to spend.

Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice.  Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice.





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