Funding Buy-Sell Agreements with Life Insurance

A Buy-Sell Agreement (also known as a business continuation agreement) is a legally binding contract between business owners that dictates what happens to a partner's share of the business if they die, become disabled, or retire. Without a formal agreement in place, the death of a partner could lead to the forced liquidation of the company, or the surviving partners could find themselves in business with the deceased partner’s heirs, who may lack the expertise or interest to run the company.

For these agreements to be effective, they must be funded. While there are several ways to fund a buy-sell agreement—such as using cash reserves, taking out loans, or selling assets—life insurance is the most common and efficient method. It ensures that the exact amount of cash needed is available immediately upon the death of an owner. To master this topic for your complete Life & Annuities exam guide, you must understand the two primary structures: Cross-Purchase and Entity-Purchase (Stock Redemption).

In a Cross-Purchase Plan, each partner or shareholder purchases a life insurance policy on the life of every other partner. If one partner dies, the surviving partners receive the death benefit tax-free and use those funds to purchase the deceased partner's interest from their estate.

The primary advantage of this plan is that the surviving partners receive an increase in cost basis for their ownership in the company. However, the disadvantage is the sheer number of policies required as the number of partners grows. The formula to determine the number of policies needed is n × (n - 1), where 'n' is the number of partners.

• 2 Partners: 2 policies (A buys on B; B buys on A)
• 3 Partners: 6 policies
• 5 Partners: 20 policies

Because of this geometric growth in the number of policies, Cross-Purchase plans are typically only used for small businesses with two or three owners. You can find more scenarios like this in our practice Life & Annuities questions.

In an Entity-Purchase Plan (often called a Stock Redemption plan in corporations), the business itself is the owner, premium payer, and beneficiary of the life insurance policies on each partner's life. When a partner dies, the business receives the death benefit and uses the cash to buy back (redeem) the deceased partner's shares.

This structure is much simpler for larger groups because the business only needs to maintain one policy per partner. If there are five partners, the business only buys five policies. The downside is that the surviving partners do not receive a "step-up" in their cost basis, which could lead to higher capital gains taxes if they eventually sell their shares in the future.

While death is the most common trigger, comprehensive buy-sell agreements also address disability. A Disability Buy-Out policy provides the funds to buy out a partner who becomes totally and permanently disabled. These policies usually have a long elimination period (such as one or two years) to ensure the disability is truly permanent before the buy-out is triggered.

Some businesses use a Wait-and-See Buy-Sell, which is a hybrid approach. It allows the business entity the first option to buy the shares; if the entity passes, the individual partners have the second option; and if they pass, the entity is finally required to buy any remaining shares. This provides maximum flexibility for tax planning at the time of the event.