Buy-Sell Agreements: Life Insurance Fact vs. Fiction

A buy-sell life insurance agreement is typically funded through a term life insurance policy whose purpose is to provide funding to the surviving business partner that will allow him or her to buy the business. In this most basic arrangement, the insurance policy provides immediate payment so that the business operations can continue. A drawn-out probate process can thus be avoided.

Unfortunately, while a buy-sell agreement is important in business partnerships, the truth is that executing such an agreement is more difficult than it appears. The agreement generally does allow the surviving partner to buy out the deceased partner's share in the business for fair market value. However, how the fair value is determined is typically up for dispute, and the transaction can be delayed as a result.

Cross Purchase Buy-Sell Agreements

In a cross purchase buy-sell agreement, multiple partners in a business each purchase a separate life insurance policy on the other business partner. In the event of a partner’s death, insurance is designed to provide the necessary funding to allow the remaining partner to buy out the deceased partner’s share of the business.

However, as noted, complications can arise in the determination of the fair value of the business. Furthermore, it can be problematic if the deceased partner's dependents or beneficiaries want to protect their deceased family member's interest in the business instead of receiving payment for the deceased partner’s share.

Entity Purchase Life Insurance Agreements

Under an entity purchase life insurance agreement, the business itself owns the insurance policy on each partner in the business and pays out the fair market value of the deceased partner's share of the business to his or her heirs. This approach limits the number of policies necessary and can be a simpler agreement to enforce. However, the fair-market-value determination can still create problems.

In any buy-sell agreement, it is critical that the business partners establish strict guidelines both for how the business value will be determined and what rights the remaining partners will have. In addition to addressing the death of a partner, the agreement should anticipate other scenarios, like the permanent disability of a partner or the wish of a partner to sell his or her share of the business.
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