Funding a Buy-Sell Agreement: Compare Your Options

Maybe a co-owner has died, or a partner wants out, and a buy-sell agreement is now in front of you. The first question is usually where the money will come from.

There is no single best way to fund a buy-sell agreement. Most owners choose among cash reserves, installment or loan payments, and life insurance. Each one trades speed, cost, and cash flow differently, so the right mix depends on the facts of the business.

What a buy-sell agreement is meant to do

A buy-sell agreement sets the terms for what happens to an owner’s share when that owner dies, becomes disabled, retires, or leaves. It names who may buy the share, at what price, and how the process runs. That keeps ownership from passing to someone the remaining owners did not choose.

The agreement sets the price and the process. It does not supply the cash. Funding is a separate question, and it’s the one that tends to come up fastest.

A co-owner’s death can come with little warning. The remaining owners may have to pay quickly, and the business may not have that money on hand.

The price is often based on a fair-value standard. Under 26 C.F.R. § 20.2031-3, the fair market value of a decedent’s interest in a business, such as a partnership or proprietorship, is the net amount a willing buyer would pay a willing seller, with neither under any pressure to buy or sell and both reasonably informed of the relevant facts. A fair appraisal of the business’s assets, including goodwill, is part of that test. Valuation is where many agreements go stale, so check it when the business changes.

What are the three main ways to fund the buyout?

The three main methods are cash reserves, installment or loan payments, and life insurance.

Cash reserves are money the business or owners set aside over time. Cash is ready when it’s needed. But money held back is money not used for operations or growth, and reserves may fall short if an owner dies early.

Installment or loan payments spread the price over time, paid to the departing owner or the estate. The business keeps its cash on hand. Payments can strain cash flow for years, and they may continue after the buyer’s own situation changes.

Life insurance pays a death benefit to the buying party when the insured dies, so cash arrives when it’s needed. It funds a buyout at death. It does not pay out for a retirement or departure while the insured is alive. See buy-sell agreement insurance for the policy side.

How do cross-purchase and entity-purchase funding differ?

In a cross-purchase, each owner buys a policy on the others. In an entity-purchase, the business buys and owns the policies.

In a cross-purchase, each owner pays the premiums on policies covering the other owners. The death benefit goes to the surviving owners directly. The number of policies grows fast. Three owners need six policies, because each owner insures the other two.

In an entity-purchase, also called a redemption, the business pays the premiums and owns the policies. The business needs one policy on each owner. There are fewer policies to track, but the business carries the premiums.

Fla. Stat. § 627.404 provides that an individual party to a contract for the purchase or sale of an interest in any business entity has an insurable interest in the life of each other party to such contract, for the purpose of such contract only. See Fla. Stat. § 627.404.

Tax results depend on the facts, including the entity type and the agreement’s terms. The IRS guidance on life insurance proceeds explains that taxability turns on those facts. Check the choice against the operating or shareholder agreement before anyone signs.

Is term or whole life better for a buy-sell agreement?

Term life covers a set period, and whole life covers the insured’s lifetime. Neither one fits every agreement.

FINRA’s guide to insurance types explains that term life covers a limited period. Whole or permanent life covers a lifetime and has a cash-value feature.

Term fits a buyout expected within the term. Coverage ends when the term ends, so a buyout after that date would have no death benefit behind it.

Whole life can stay in force as long as premiums are paid under the policy’s terms. Guaranteed values and non-guaranteed values are shown separately. Dividends, where a policy pays them, are not guaranteed.

Neither type is an investment or a promise of returns. Use the names term life insurance policy and whole life insurance policy when you compare them.

Nischay Rawal acts as a licensed insurance agent for the policies described here. Insurance is offered by the licensed agent, separately from the accounting practice. Fla. Stat. § 626.9531 requires an agent, when soliciting or selling insurance products, to clearly indicate to prospective insureds that they are acting as insurance agents with regard to those products and the identified insurers or other authorized risk bearing entities.

How do you keep the funding matched to the business?

Review the funding whenever the business’s value, owners, or entity type changes.

Valuation moves as the business grows, adds or loses an owner, or changes its entity type. The buyout price may move with it, so policy amounts may need review.

Ownership and beneficiary designations must match the funding plan in the agreement. If they don’t match, the money may not reach the buyer the agreement names.

Fla. Stat. § 627.404 gives a business entity an insurable interest in the life, body, and health of any of the owners, directors, officers, partners, and managers of the business entity or any affiliate or subsidiary, or of key employees or key persons, if written consent is obtained from them before the insurance is purchased, and the business entity or affiliate or subsidiary may not retaliate or take adverse action against a key employee or key person who does not consent. See Fla. Stat. § 627.404.

Applying for life insurance involves health questions, and issue may depend on insurability. Age matters too. Under Fla. Stat. § 627.456, a misstated age adjusts the benefit to what the premium would have bought at the correct age.

The premium, face amount, and any age-based change are set out in the policy. Read them with the agent before buying.

What are the tradeoffs and disadvantages?

Every method has a cost. Premiums are ongoing, reserves tie up cash, and installments strain cash flow.

Life insurance premiums are an ongoing cost for as long as the policy is kept. Cash reserves can tie up money the business needs for operations. Installment payments can strain cash flow for years.

Health can change after a plan is made. A policy may not be issued if the insured’s health changes, which can leave a funding gap.

Cash values and policy loans affect coverage. FINRA on exchanging life insurance notes that exchanging or replacing a policy can involve surrender charges and cash-value considerations. Check before any borrowing or switch.

A funding plan can also fall out of step. If an owner dies or leaves and the policies are not updated, the money may not match the buyout price.

How does a coverage review work?

A coverage review is our first meeting on how your buy-sell agreement could be funded. We look at the agreement, the entity type, the business’s cash flow, and its valuation. Then we compare cash reserves, installments, and insurance against those facts.

Fees for a coverage review and for any accounting engagement are disclosed in writing before work begins, and any commission the licensed agent earns on an insurance policy is disclosed in writing before the engagement, in an engagement letter the client signs. Insurance is offered by the licensed agent, separately from the accounting practice.

If you’re handling this for a co-owner or family member, gather the agreement and any recent valuation first.

Reach out to our team to set up a coverage review of your buy-sell funding, and contact us when you’re ready.