Fund Your Buy-Sell Agreement With Life Insurance

Buy Sell Agreement Life Insurance: How Florida Owners Fund a Buyout

Buy sell agreement life insurance pays the agreed buyout price when an owner dies. The surviving owners or the company use the proceeds to buy the deceased owner’s share, so the buyout doesn’t depend on cash on hand. This guide explains how the funding works, the choices owners must make, and the tax questions a CPA reviews.

How buy sell agreement life insurance pays for a buyout

Life insurance pays the agreed buyout price to the surviving owners or the company when an owner dies. The payment comes from the policy, not from the business bank account.

A buy-sell agreement is a written contract among owners. It sets what happens to an owner’s interest when that owner leaves, retires, becomes disabled, or dies. The SBA guidance on operating agreements notes that an operating agreement can set buy-sell procedures for transferring an interest or handling an owner’s death.

The death benefit is the amount the insurer pays when the insured dies while the policy is in force. In a funded plan, that amount is set to match the price the agreement sets.

Without funding, a buyout can stall. The deceased owner’s estate waits for payment. The survivors may need to borrow, sell assets, or pay over several years. Each path can strain cash flow at the same time the family is dealing with a loss.

Nischay Rawal, licensed insurance agent, offers insurance separately from the accounting practice of NR CPAs & Business Advisors. Nischay Rawal is licensed in Florida.

What a buy sell agreement sets in advance

A buy sell agreement sets who may buy an owner’s interest, who must sell, and the price or formula used. Those answers decide how much insurance the plan needs.

Common triggers include death, disability, retirement, departure, and divorce. Life insurance funds only the death trigger. The agreement still has to address the others, and the funding plan for each should be clear.

The terms should be in writing, signed, and reviewed as the business changes. If the business is a Florida corporation, Florida law allows an agreement among shareholders of this kind to be set forth in the articles of incorporation or bylaws approved by all shareholders, or in a written agreement signed by all shareholders at the time and made known to the corporation.

A written agreement also helps the owners agree on the facts before a crisis. For more on the purpose of these agreements, see the buy-sell agreement purpose guide.

Cross-purchase and entity-purchase: the two funding structures

In a cross-purchase plan, each owner buys and owns a policy on each of the other owners. When one owner dies, the survivors receive the proceeds and buy the deceased owner’s interest.

In an entity-purchase plan, the company buys and owns a policy on each owner. When an owner dies, the company receives the proceeds and redeems that owner’s interest. Some agreements call this a stock redemption.

The number of owners changes the math. Under a cross-purchase plan, three owners need six policies, and four owners need twelve. Under an entity-purchase plan, three owners need three policies, and four owners need four.

The choice affects who pays premiums, who owns the cash value, and how the company’s books record the policies. Those effects are why the structure should be reviewed before any policy is bought. You can read more in the cross-purchase buy-sell life insurance guide and the entity-purchase guide.

Policy ownership, the ownership clause and the insuring agreement

The policy owner controls the policy. The insured is the person whose life is covered. The premium payer and the beneficiary are separate roles. These roles must match the buy-sell agreement.

If the company pays premiums but a surviving owner is the beneficiary, the agreement and the policy can point in different directions. Matching these roles on paper before the policy is issued prevents that gap.

The ownership clause sets the rights of the policy owner. Those rights can include changing the beneficiary and borrowing against the policy. The insuring agreement is the insurer’s promise to pay the death benefit when the insured dies while the policy is in force. Both are explained in the ownership clause guide and the insuring agreement guide.

Ownership also matters for estate tax. Under 26 U.S.C. § 2042, insurance receivable by beneficiaries other than the executor can count in the deceased owner’s gross estate if the owner held an incident of ownership at death. A reversionary interest counts only if its value exceeded 5 percent of the policy’s value just before death.

Term or whole life for buyout funding

Term life insurance covers a set number of years. Coverage ends when that period ends. The question is whether that period matches the years an owner expects to stay in the business. More on that is in the term life insurance guide.

Whole life insurance is permanent coverage. It builds cash value. Cash value is a feature of the whole life insurance policy that can be borrowed against or received on surrender. Under Fla. Stat. § 627.458, an insurer can advance a policy loan after the policy has a cash surrender value and no premium is in default. Fla. Stat. § 627.458 reads: “The loan value of the policy shall be at least equal to the cash surrender value at the end of the then-current policy year, except that the insurer may deduct, either from such loan value or from the proceeds of the loan, any existing indebtedness not already deducted in determining such cash surrender value, including any interest then accrued but not due, any unpaid balance of the premium for the current policy year, and interest on the loan to the end of the current policy year.” That section does not apply to term policies or to term insurance benefits provided by riders or supplemental policy provisions.

A policy loan lowers the amount left for the death benefit if the loan and interest are not repaid. Keep that in mind when the agreed price and the coverage amount are set. The whole life insurance guide covers these points in more detail.

Keep guaranteed values separate from non-guaranteed values. Dividends are not guaranteed. Premiums are the amounts paid to keep the policy in force, and any age-based change in premium should be stated in writing. Florida law requires a grace period of not less than 30 days for paying a premium after the first (Fla. Stat. § 627.453).

Setting the amount: valuation and keeping coverage matched

The coverage amount should match the price the agreement sets. The price must be reviewed as the business changes.

Agreements usually set the price in one of three ways. A fixed price is a dollar number the owners update on a schedule. A formula ties the price to a measure such as earnings. An appraisal sets the price at the time of death. Each method changes how much insurance the plan needs.

A fixed price can go stale. A business that grows in value can outgrow its coverage. An appraisal at death can produce a number the policies do not match. Review the amount on a regular schedule, not only when the agreement is signed.

Common gaps include an agreement that hasn’t been updated, coverage amounts that don’t match the agreed price, and premiums that have fallen behind. A lapsed policy can’t fund a buyout.

Bring these facts to a coverage review: the current valuation, each owner’s ownership percentage, and the years each owner expects to remain involved.

Tax and accounting questions a CPA reviews

A CPA reviews how the policy is owned, who pays premiums, and who receives proceeds. Those choices shape the tax results.

Under 26 U.S.C. § 101, gross income does not include amounts received under a life insurance contract when paid by reason of the insured’s death, with listed exceptions. Interest on proceeds the insurer holds after death is treated differently. Amounts received under agreements to which subsection (d) applies are generally taxable to the extent they are not excluded by proration.

Federal law also sets tests for what counts as life insurance. Under 26 U.S.C. § 7702, a contract must meet the cash value accumulation test or the guideline premium and cash value corridor requirements to be a life insurance contract for tax purposes.

Estate tax liquidity is another issue. Under 26 U.S.C. § 6166, if the decedent was a U.S. citizen or resident at death and an interest in a closely held business included in the gross estate exceeds 35 percent of the adjusted gross estate, the executor may elect to pay part or all of the estate tax in 2 or more, but not more than 10, equal installments.

Changing who owns a policy later can have tax effects. Check with the CPA before any ownership change. The accounting practice handles tax and accounting work. Insurance is offered by Nischay Rawal, licensed insurance agent, separately from that practice.

Key person insurance and related coverage

Key person insurance pays the company when a key owner or employee dies. Buy-sell funding pays the price to buy the deceased owner’s interest. The two coverages solve different problems.

Some owners hold both. The policies should be set up so the same loss isn’t counted twice. A plan that pays the company and the buyout from one event needs careful drafting.

Check whether an existing life insurance policy was written for the buyout or for family needs. A policy written for family needs may not fit the agreement. A policy written for the buyout may not cover the family’s needs.

The key person insurance guide explains how the two coverages differ.

Florida business owners and local considerations

Florida owners use the same structures as owners elsewhere. The agreement and the policies are reviewed against Florida rules and the owner’s own facts. That applies to owners in Miami, Fort Lauderdale, West Palm Beach, Orlando, Tampa, and Jacksonville.

Under Fla. Stat. § 626.112, a person must be licensed and appointed to act as an insurance agent. Fla. Stat. § 626.112 reads: “(1)(a) No person may be, act as, or advertise or hold himself or herself out to be an insurance agent, insurance adjuster, or customer representative unless he or she is currently licensed by the department and appointed by an appropriate appointing entity or person.” Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the accounting practice.

The NAIC Life Insurance Buyer’s Guide covers term versus permanent coverage, how much to buy, and questions to ask. The Florida life insurance consumer guide covers cash value, policy loans, and beneficiaries.

Nischay Rawal is paid commission on insurance sold. That compensation is disclosed in writing before the engagement begins. Florida also has state-specific pages for life insurance in Florida and life insurance in Miami.

Bring your buy sell agreement to a coverage review

Life insurance pays the agreed price when an owner dies. Your buy sell agreement needs that money in place before a partner’s death, not after it.

Picture a partner who has died. The surviving owners must buy the deceased owner’s interest, but no cash is set aside for it. A coverage review can show whether the current policies match the agreement.

Bring the signed agreement, the current valuation, the ownership percentages, the list of policies, and the years each owner expects to stay involved. Nischay Rawal, licensed insurance agent, will review how these pieces fit together. Fees for accounting and insurance work are disclosed in writing before any work begins.

If a partner’s death would leave you without cash to buy out their share, contact NR CPAs to schedule a coverage review.