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How to control who takes over the family business

by Susan Wright | Contributor
September 11, 2020

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If you’re the owner or a partner in a family business, you are likely well aware of how much time, effort and money goes into creating a company and keeping it afloat in all types of market and economic environments. Because of that, when it’s time for you to move on, you may be highly selective in terms of who will take over at the helm.

In many instances, various loved ones may not necessarily be the best choice for passing the baton. So, how can you ensure that all of your hard work will be carried on by people you want to keep the business running, and not by those that you don’t? One strategy is through a buy-sell agreement.

How can a buy-sell agreement prevent others from becoming a part owner of your company?

A buy-sell agreement is a legally binding contract that lays out how an owner’s or partner’s share of a business may be reassigned if he or she dies or otherwise leaves the company. Buy-sell agreements generally require that the business share be sold either to the company or to the remaining members of the business.

Typically, then, this type of agreement will lay out that the deceased individual’s share of the business be sold to the remaining partners or owners – and in doing so, it can also keep unwanted family members out of arm’s reach when it comes to inheriting the company.

But, what if the remaining business partners don’t have the cash that is needed to purchase the decedent’s share?

The answer is through life insurance proceeds.

There are actually a few different ways to structure a buy-sell agreement. These include:

  • Cross-purchase
  • Redemption/entity purchase
  • Combination of a cross-purchase and a redemption/entity purchase

Cross-purchase agreements

A cross-purchase agreement is a particular type of buy-sell arrangement that allows a company’s partners or other shareholders to purchase the interest or shares of a partner who has died.

In this case, each of the owners/partners purchase life insurance coverage on all of the other owners or partners and list themselves as the beneficiaries. Then, if one of them should pass away, the policy’s proceeds will be paid out to the surviving owners/partners, and the funds can be used to purchase the decedent’s share of the company.

In addition to providing instant liquidity for the purchase of the deceased partner’s share of the business, there are some other advantages that the life insurance coverage provides, as well, such as:

  • The life insurance proceeds are received tax-free by the beneficiaries, so they essentially have use of 100% of the money to apply toward purchasing the insured’s share of the company.
  • Life insurance proceeds from a cross-purchase agreement are not subject to the claims of the decedent’s creditors, because the other owners/partners own the policy, not the decedent.

Redemption/entity-purchase agreement

A redemption agreement – which is also oftentimes referred to as an entity purchase agreement – is a type of business succession plan that is used by companies that have more than just one owner.

With this strategy, the company takes out a life insurance policy on the lives of all of its owners or partners, with the premiums paid for by the business. The life insurance coverage is in an amount that’s equal to the owner or partner’s stake.

If the owner/partner dies, then the proceeds from the life insurance policy are used to pay his or her estate for its share of the company. The business operations are then carried on by the remaining owners or partners.

If the business is operated as a corporation, the entity-purchase agreement is usually referred to as a stock redemption agreement. In this instance, the company itself enters into an agreement with each of its owners or partners for purchasing the deceased individual’s share of the business.

With this type of agreement, it is also required that the deceased business owner’s estate sell its interest in the company. Likewise, the business entity is also then required to purchase the deceased person’s share. The amount of his or her share of the company is typically based on either a fixed dollar amount or on a set formula that can determine the appropriate amount.

Cross purchase agreement versus Redemption entity purchase

What items should be considered regarding the use of life insurance for buy-sell agreements?

While a buy-sell agreement can provide a way to keep a business running – even in the event of the death of a partners or owner – there are still some factors to keep in mind. First, the life insurance coverage that is used in this type of business succession strategy is not a substitute for having a personal policy that can protect a surviving spouse and other loved ones financially.

In addition, the life insurance premium for a buy-sell agreement is typically paid via the insured’s personal funds and not by the business. Therefore, it is important to ensure that this payment is budgeted for.

Is a buy-sell agreement the right strategy for the transfer of your business?

While a buy-sell agreement can offer a number of nice benefits that pertain to the transfer of a business owner or partner’s shares, it may not be the best strategy for all companies. If you’re seeking more information on business succession planning, talking with an Alliance America professional can help.

Alliance America can help

Alliance America is an insurance and financial services company. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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