Is Life Insurance Funding Your Buy-Sell Agreement? It’s Time to Dust Both Off

A version of this article appeared in Construction Executive on April 30, 2015.

Contractors commonly use life insurance as a funding mechanism for buy-sell planning and insuring key employees. Since death is a common trigger in a buy-sell agreement, life insurance, when used as the funding mechanism for the agreement, provides the immediate liquidity to fund the buyout when the need arises. It’s an elegant solution, but complications do arise. When they do, it’s usually a question of whether the insurance is being managed, monitored, and serviced as it ought to be.

Life insurance as an industry isn’t usually associated with client service. As a result, policyholders who don’t consistently monitor their policies can find themselves faced with disastrous tax ramifications. For instance, in calculating gain on a policy, the cash surrender value is added to any outstanding loans on the policy-less-cost basis. If a policy lapses, no cash value is paid out. But if there’s a $100,000 loan on the policy and the cost basis is $50,000, then the policyholder (the company) may be liable for paying income taxes on $50,000 even though nothing was received. The tax implications are complicated, and they can be severe enough to diminish the goals you set out to accomplish when the policy was created. For this reason, business owners should regularly review their buy-sell agreements and their insurance policies individually as well as in relation to each other.

Buy-sell agreements don’t need to be complicated to be effective. Lincoln Swaggart, president of the Oregon-based general contractor Swaggart Brothers Inc., said the company set up its life insurance–funded buy-sell agreement at the company’s inception, a decision prompted mostly by his own background as an insurance broker. “Originally it was set up as an afterthought,” he said. “When the company was first starting out, there was no value and nothing to fight over. It was simple: If someone dies, the CPA will value the company.”

Note that there are options other than life insurance for funding a buy-sell agreement. For example, owners can complete a buyout with a loan or create a sinking fund (or savings, so to speak). But life insurance provides an easy method. After all, it’s a simple mechanism for paying out cash at the time it’s needed.

“For the security of surviving owners and the survival of the business, life insurance is really the only funding mechanism that should be used,” Swaggart said. “Funding a buy-sell agreement from business capital can cripple that business later on. Even if a business has significant value, it’s not always liquid, so it would be rare for a business to actually manage that buyout.”

Common Issues with Buy-Sell Agreements

One of the problems owners often face is incomplete buy-sell agreements. Frequently, business owners begin the process of creating a buy-sell agreement only to leave it sitting in draft form, never signed. The result is a nonbinding agreement. If your company has an incomplete buy-sell agreement, it’s important to complete the process as soon as possible.

Another common problem is agreements that talk about what will happen at death or disability but miss other critical elements. Is the agreement actually funded? Is there a plan and mechanism to carry out its goals? Clients often have an agreement but never create a plan to follow through. For example, an agreement may call for a buyout at death, but if no insurance, funding pool, or loan arrangement is established, funding the agreement could be problematic if an owner dies.

Another concern is whether the insurance ownership structure matches the agreement. The obligation to carry out the agreement lies in the wording of the actual buy-sell agreement, so the funding mechanism (in this case, the insurance) must match the agreement. If the agreement says that the individual owners will buy out the deceased owner, but the insurance is owned by the company, then the individuals, who are themselves required to buy out the estate, have no money or method for doing so—and negative tax consequences may be the result. In this situation, the question becomes: How does the surviving owner get the cash? Does the company distribute the proceeds to the surviving owner? If so, is this income taxable? Is it a distribution, and does it reduce basis in the policy? What does it mean to the deceased owner’s estate? Does the estate receive a distribution as well? The questions that result can become complex, and unplanned tax exposure that follows can take vital dollars away from the buyout plan.

Life Insurance That Meets Your Needs

Of course, having the right insurance up front is also critical. Is the insurance product suitable for the goals of the arrangement? For example, if the owners plan to sell the business within a 10-year period, then a term policy is probably the most appropriate product. If you instead buy a permanent product, you’re probably paying more money for something you don’t need. Furthermore, a permanent product may result in tax consequences, because if the business does sell, you’ll be left not knowing what to do with your policies.

It’s always important to do annual reviews of your policies, particularly if the insurance you have relies on the market. Because market performance can affect policy performance, downturns can result in policies expiring sooner than expected, requiring more in premiums, or even inadvertently generating loans.

In addition, insurance companies can undergo changes and lose their financial stability, or the original policy may have been placed with a low-grade company in order to save on premiums. Since your company has matured, it may no longer make sense to sacrifice financial stability for a few dollars. 

Finally, circumstances change; values change. When an event changes the nature or outcome of your business, it’s important to review your insurance alongside your buy-sell agreement so that both can accommodate the changes and continue to work together.

When Swaggart Brothers revisited its own buy-sell agreement and corresponding life insurance policies 10 years after the originals were put in place, it was to account for new concerns. “We set up valuations for if we wanted to leave or sell, but under a voluntary exit we figured the terms wouldn’t really be used—we’d just make a deal,” Swaggart said. “If one brother wanted to retire, the buy-sell would be our backup if we couldn’t make a deal. But the biggest driver to revamp it was to prepare for situations out of our control: death and divorce.”

Insurance Needs TLC

Insurance is often a forgotten investment. Companies think if they pay their premiums, they’re good to go, but policies require regular and careful reviews. Oftentimes term periods have expired, or, without realizing it, companies continue to pay extravagant increases in premiums due to poor performance.

Neglect makes it easy for insurance to become misaligned with your buy-sell agreement—either in product, amount, or need—and the result is a policy that no longer accomplishes what you created it to do. The best approach is to integrate it with other aspects of your business plan that you revisit frequently.

“Most parties handle buy-sells like we do: We write one up and then stick it in a drawer for 10 years,” Swaggart said. “But it really should be reviewed regularly and kept on the forefront to make sure all owners understand it.”

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To learn more about buy-sell agreements, life insurance, and other ways you can prepare your business for both foreseen and unforeseen events in its life cycle, contact your Moss Adams professional.