Life Insurance Figures in Business Succession Planning

Q.: I own a business with two other equal owners. We believe that the business is worth more than $750,000 if we were to sell it. The business owns a total of three policies of term life insurance, $250,000 on each of us, payable to the business. If one of us dies, will that owner's family receive the money?
A.: No. The business receives the money as the designated beneficiary of the life insurance policy.

Q.: Does the deceased owner's family inherit the share of the business?
A.: Maybe. It depends on several factors. Transfer of a share in the business may be restricted by written documents commonly known as "buy-sell" agreements. Otherwise, the deceased owner's share is left to the person(s) designated in his or her will.

Q.: What are buy-sell agreements?
A.: They are written agreements between: a) a business and an owner; b) the owners; or c) a combination of (a) and (b). There are two major types. The first is a "redemption agreement" in which the business agrees to buy the owner's interest upon a "triggering event" (such as that owner's death). The second is a "cross-purchase agreement" in which the owners agree to buy the share of another owner upon a triggering event. The buy-sell agreement may stand alone or may be incorporated into other, more comprehensive agreements, such as partnership agreements or close corporation agreements. The agreements usually will address conditions which trigger a buy-out, as well as the price and terms of payment.

Q.: If there is a buy-sell agreement, must the business buy the deceased owner's share of the business from the deceased owner's family, and must the family agree to the sale?
A.: Yes, if the agreement requires a sale.

Q.: If the family members of a deceased owner receives a business share through inheritance, can they sell it if they wish to?
A.: Yes, assuming there are no restrictions on the sale. The family can sell to anyone, including the other owners. The sale price and the terms are all subject to negotiation.

Q.: Is the business required to use the life insurance money to "buy out" the
deceased owner?
A.: No, not unless the business and the owner have agreed to this in writing.

Q.: What are the advantages of life insurance and a buy-sell agreement?
A.: Life insurance in combination with a buy-sell agreement provides liquidity (available cash), assures all the owners of a market for the sale of their share in the event of death and provides protection for their families. It further ensures that the business and surviving owners will not have to borrow money, reduce working capital or divert future earnings to buy the share. The surviving owners also avoid potential meddling and disputes caused by those who may have inherited or bought the deceased owner's share.

The family of the deceased owner does not have to worry about finding a buyer and is assured of receiving cash shortly following the death in order to pay bills, estate taxes, etc. They also do not have to worry about overseeing and protecting their share of the business.

Q.: What is the best way to require the business to buy the deceased owner's share?
A.: Prior to someone's death, the business owners sign an agreement which obligates the business to buy an owner's share should one of them die. The deceased owner's estate is likewise required to sell the share to the business. Of course, the availability of life insurance to fund the buyout is dependent upon health and cost.

Q.: What determines the price of the deceased owner's share?
A.: The price is usually defined in the written agreement and may be based on many factors. For example, the business may operate in an industry which uses traditional measures of value, such as "book" value, one year's gross revenues, one year's earnings, etc. A price may be set periodically, or it may be based on a qualified appraisal or on a formula.

Q.: If life insurance proceeds are less than the defined price of the business share, what happens?
A.: Usually, the written agreement will anticipate that possibility and provide an alternative way to fund the purchase price. For example, the business may either borrow the difference or pay it over time in installments.

–by Paul S. Klug, an attorney with the Cleveland firm, Ziegler Metzger LLP.