Buy-Sell Funding with Life Insurance

Within a closely held corporation, shareholders are often concerned about what might occur if one of the owners dies. Will the deceased shareholder’s family retain the economic value of the corporate interest? Can the surviving owners avoid interference from the deceased shareholder’s family? Will the survivors have the economic resources to redeem the deceased owner’s interest? Given these concerns, corporate owners are best served by entering into a buy-sell agreement while they are all alive.

Owners usually choose from two basic types of buy-sell agreements. With a cross-purchase agreement, each owner of the corporation purchases an insurance policy on the other shareholders. The purchaser is both owner and beneficiary of the policies. Upon the death of a shareholder, the other shareholders are then able to use the life insurance proceeds to purchase the deceased owner’s shares. Another commonly used type of agreement is a stock redemption agreement, in which the corporation owns policies on the lives of the stockholders. When a shareholder dies, the corporation buys the deceased stockholder’s interest in the company with the insurance proceeds.

Funding of the Buy-Sell Agreement

Any buy-sell agreement requires a decision regarding the type of insurance policy to purchase. The initial choice is between Term and Permanent life insurance. Premiums for Term life insurance increase throughout the coverage period, whereas premiums for Permanent life are level throughout the coverage period. If the shareholder dies in the first few years of coverage, the cost of Term insurance will be less than the cost of Permanent life insurance. Conversely, the cost of term insurance may be much greater than Permanent life if an individual exceeds the life expectancy used for underwriting the Permanent life insurance policies.

In addition to cost, insurability is a key consideration. The ability to maintain life insurance throughout a shareholder’s life is important. Permanent life policies grant coverage until death that may not be cancelled by the insurance company. This feature has persuaded many that Permanent life insurance is the proper means to finance corporate buy-sell agreements. The Term life insurance industry has, however, modified its products so that policyholders can purchase term life with the same benefit. This can be accomplished with either a guaranteed insurability option or lengthy (20- to 30-year) policy terms. The addition of a guaranteed insurability option to a term policy will increase the cost of the term insurance. The increased premium, however, will still be lower than Permanent life premiums in the beginning years. Owners, therefore, must weigh the escalating premium structure of term insurance against the early returns that might be realized by purchasing less-expensive term insurance and investing the premiums saved.