Funding a Buy-Sell Agreement: Understanding the Basics

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When business owners agree to a buy-sell agreement, they must ensure that there are funds available to complete the transaction if a triggering event occurs, such as the death, disability, or retirement of one of the owners. There are three traditional methods to fund a buy-sell agreement: debt, cash reserves, and life insurance. Each method has its pros and cons, depending on the specific needs and financial situation of the business.

What is a Buy-Sell Agreement?

A buy-sell agreement is an arrangement by which the surviving owners of a business entity agree to purchase the interest of a withdrawing or deceased owner of the same entity. The business entity may be a partnership or a corporation, and the owners may be partners or shareholders. Buy-sell agreements are often referred to as “buyout agreements” or “buy and sell” agreements. These agreements play an important role in estate planning, particularly for businesses, as they ensure the continuity of the business without interruption after the death of an owner and provide liquidity to the deceased owner’s estate

1. Traditional Methods of Funding Buy-Sell Agreements

Debt Financing

Debt financing involves borrowing money to fund the buy-sell agreement. The business or its owners may take out a loan to cover the cost of buying out a departing owner. While this method allows for structured payments over time, it comes with significant risks. The primary concern is that the business must be able to repay the loan, which could place a financial burden on the company, especially if the loan is large or if the business experiences downturns.

Example: Imagine two business partners, Joe and Sarah, who set up a buy-sell agreement funded by a loan. If Joe dies unexpectedly, Sarah can take out a loan to purchase Joe’s share of the business. However, if the business struggles to meet financial obligations, repaying the loan could become difficult, potentially affecting Sarah’s ability to maintain ownership or leadership of the business.

Cash Reserves

Some businesses choose to use cash reserves to fund a buy-sell agreement. This method requires the company or the owners to set aside a significant amount of cash for future use. The primary advantage of this approach is that it avoids debt. However, it may not always be realistic, especially if the company doesn't have sufficient cash flow to build these reserves, or if the owners' personal finances are tied up elsewhere.

Example: If a small family-owned business is planning to use cash reserves to fund a buy-sell agreement, the company would need to ensure that there is enough money available in the account to cover the cost if one of the owners needs to sell their share. For many businesses, this could mean putting away a substantial portion of annual earnings, which may not always be feasible.

2. Using Life Insurance to Fund a Buy-Sell Agreement

Of the three traditional funding methods, life insurance is often the preferred choice for many business owners due to its affordability, speed, and tax benefits. Life insurance is particularly beneficial because the premiums are typically lower than the cost of borrowing money, and the death benefit is generally tax-free, making it an attractive option for funding buy-sell agreements.

The Benefits of Life Insurance

One of the key benefits of using life insurance to fund a buy-sell agreement is that it provides flexibility. If one business owner passes away, the death benefit from the life insurance policy can be used to buy out their share of the business. The business doesn't need to scramble for cash or worry about taking on debt—it simply accesses the life insurance proceeds.

Example: Continuing with Joe and Sarah, instead of taking out a loan, they could each take out a life insurance policy on each other’s lives. If Joe dies, Sarah can immediately use the life insurance proceeds to purchase Joe's share of the business. The advantage here is that Sarah doesn't need to dip into her own savings or take out a loan.

Tax-Free Proceeds

Another significant benefit of life insurance is the tax treatment. Generally, life insurance death benefits are paid out income tax-free to the beneficiary. This means that the proceeds from a life insurance policy used to fund a buy-sell agreement will not be subject to income tax, ensuring that the full amount is available to facilitate the purchase of the deceased owner’s share.

However, there are exceptions to this rule. Two notable ones are Transfer-for-Value (TFV) issues and Employer-Owned Life Insurance (EOLI) policies.

Transfer-for-Value Rule

The TFV rule can complicate life insurance funding in certain situations, particularly in hybrid buy-sell agreements. If the buy-sell agreement requires the surviving owners to purchase the deceased owner’s shares from the business, the TFV rule may not be a significant concern. However, if shares are being transferred to other business owners or outside parties, the TFV rule could cause the life insurance proceeds to become taxable. It’s important to ensure that the agreement is structured correctly to avoid this issue.

Employer-Owned Life Insurance (EOLI)

EOLI policies are subject to special rules under I.R.C. §101(j). To ensure that the life insurance proceeds are not taxable, the business must meet certain notice and consent requirements. The employee must be informed that they are being insured, must consent to the policy, and must understand that the business will be the beneficiary of the policy.

3. Implications of Life Insurance for Texans and Post-2024 Election

For Texas business owners, life insurance can be a very tax-efficient way to fund a buy-sell agreement. Texas does not have a state income tax, so the tax-free death benefit from life insurance will not be offset by state income tax. However, there are still federal considerations, especially in light of changes that may occur after the 2024 election.

One possible outcome of the 2024 elections could involve changes to federal estate tax laws. If the estate tax exemption is reduced (as speculated by some policymakers), the value of life insurance proceeds may be affected. Business owners should consult with their advisors to understand how these potential changes might impact their estate planning and the tax treatment of life insurance.

Example: If the estate tax exemption were reduced, business owners could see their estates subject to estate taxes upon their death, potentially leading to a large tax liability. To mitigate this, life insurance can be structured within an irrevocable life insurance trust (ILIT) to remove the policy's value from the taxable estate, ensuring that the proceeds are used efficiently to fund a buy-sell agreement and minimize tax liabilities.

Summary: The Smart Choice for Funding a Buy-Sell Agreement

Ultimately, life insurance is often the best method for funding a buy-sell agreement. It provides a cost-effective solution, flexibility, and tax advantages, while also allowing business owners to avoid the risks of debt and the challenges of cash reserves. For Texans, the lack of state income tax is an added benefit, ensuring that the life insurance proceeds can be used in full. As always, it is crucial to regularly review your buy-sell agreement and estate planning strategies, particularly in light of any changes in tax laws after the 2024 election. Consulting with an experienced tax advisor or estate planner can help ensure that your buy-sell agreement is properly funded and that your estate plan reflects your business’s needs. Reach out to us using the button below if you want to get started today!