Buy-Sell Funding: Ensuring Your Agreement Actually Works
A Promise Without Funding Is Worthless
A buy-sell agreement without funding is worthless. Learn how life insurance and disability coverage ensure your buy-sell agreement can be honored.
- A buy-sell agreement without funding is just a promise - life insurance provides instant liquidity when an owner dies
- Cross-purchase structure provides stepped-up cost basis; entity redemption is administratively simpler
- Insurance coverage must match current business value - review and adjust annually as the business grows
- Disability buy-out insurance protects against the more common risk of owner disability during working years
- Ensure policy ownership structure matches buy-sell agreement structure to avoid tax problems
The Opportunity
Why Buy-Sell Funding Matters
Life Insurance: Instant Liquidity at Death
When an owner dies, the business needs immediate capital to buy out the deceased owner's interest. Life insurance provides tax-free funds exactly when needed. Without insurance funding, the surviving owners may need to liquidate assets, take on debt, or bring in unwanted partners to satisfy the obligation.
Disability Buy-Out Coverage
Disability is often overlooked but actually more common than death during working years. Disability buy-out insurance provides funds to purchase a disabled owner's interest over time, typically after a waiting period. This protects both the disabled owner (who gets liquidity) and remaining owners (who avoid carrying a non-contributing partner).
Cross-Purchase vs Entity Purchase
Two main structures: Cross-purchase (owners buy insurance on each other) or Entity purchase (company buys insurance on all owners). Cross-purchase provides stepped-up basis to surviving owners. Entity purchase is simpler with multiple owners. Hybrid approaches combine benefits of both structures.
Valuation and Funding Alignment
The buy-sell agreement specifies how the business is valued. Insurance funding must match this valuation. If the business grows faster than insurance coverage, survivors face a funding gap. Annual reviews ensure insurance keeps pace with business value and the agreement stays current.
Implementation
Proven Strategies
Cross-Purchase with Life Insurance
Each owner purchases life insurance on the other owners. When an owner dies, surviving owners receive tax-free death benefits and use them to purchase the deceased's interest. Survivors get a stepped-up cost basis equal to the purchase price, reducing future capital gains when they eventually sell.
3 owners, business worth $6M ($2M each). Each owner buys $1M policy on each other owner ($2M total per owner). Owner A dies: Owners B and C each receive $1M tax-free, buy A's interest from estate. B and C now own 50% each with $3M cost basis (original $1M + purchased $1M).
Entity Purchase (Stock Redemption)
The business entity purchases life insurance on all owners. When an owner dies, the entity receives the death benefit and uses it to redeem (buy back) the deceased owner's shares from their estate. Simpler administration with multiple owners, but no stepped-up basis for survivors.
Same 3 owners, $6M business. Company buys $2M policy on each owner. Owner A dies: Company receives $2M tax-free, redeems A's shares. B and C now own 50% each, but cost basis remains original amount - no step-up.
Wait-and-See (Hybrid) Buy-Sell
Combines cross-purchase and entity redemption. Agreement gives the entity first option to redeem shares, then remaining owners can purchase any unredeemed shares. Provides flexibility to optimize for tax consequences at the time of the triggering event based on current circumstances.
At Owner A's death, analyze tax situation. If survivors benefit from stepped-up basis: cross-purchase. If company has accumulated earnings to distribute: entity redemption. Agreement allows either path, decision made at event.
Avoid These Pitfalls
Common Mistakes
No Funding Mechanism at All
A buy-sell agreement without funding is just a promise with no way to fulfill it. When an owner dies, surviving owners face the choice of: taking on massive debt, liquidating business assets, or defaulting on the agreement. Insurance funding ensures the promise can be kept.
Outdated Insurance Coverage
Businesses grow, but insurance coverage often stays static. A business worth $2M at agreement signing may be worth $10M today. If insurance only covers $2M, there is an $8M funding gap. Review annually and increase coverage as value grows.
Mismatched Agreement and Policy Ownership
If agreement is cross-purchase but entity owns policies (or vice versa), there are tax problems at death. The structure of insurance ownership must match the structure of the buy-sell agreement. Mismatches can result in unexpected income tax or failure to accomplish intended goals.
Questions
Common Questions
Here are the most common questions we receive about this topic.
Ask Your QuestionReady to Fund Your Buy-Sell Agreement?
Don't leave your partners or family with an unfunded promise. Let us help you implement the right funding strategy for your buy-sell agreement.