Business succession involves having a solid plan in place to deal with the retirement or departure of the principal owner or partner. While it is necessary to plan for expected events such as retirement, one must not overlook planning for unexpected events such as premature death or long-term disability.
For well organized privately held businesses, a buy-sell agreement is usually in place that outlines what happens to an owner’s share of the business if he becomes disabled or passes away. Similar to how a will sets out the wishes of an individual, a buy-sell agreement accomplishes the same for a business owner. In the unfortunate event that a business owner is forced to leave, the agreement can stipulate that a business partner purchase his shares or the shares become redeemed by the corporation. The agreement will outline how much will be paid for the shares and what the triggering event will be (death, disability, retirement). Because liquidity is required to purchase the shares of a successful business and there can be difficulty producing a large sum of cash, insurance is used to provide for this. The usage of insurance proceeds to provide capital for a buyout is called buy-sell insurance.
Disability insurance is used for a shareholder to purchase the shares of another shareholder who suffers from a long-term disability and does not look likely to manage the business again. Life insurance is used for a shareholder to purchase the shares of a deceased shareholder who passes away. It’s important for a business to add the guaranteed insurability rider to increase coverage as the business grows in size, so that there is no shortfall in funding.
There are three basic types of buy-sell arrangements.
- Cross purchase method – Also the most basic arrangement, a cross purchase method is when each shareholder agrees to purchase the shares of the deceased shareholder at the time of his death using personally owned life insurance to fund the arrangement. In the event of a shareholder’s death, the surviving shareholder receives cash from the insurance proceeds and uses it to discharge his obligation to purchase the shares from the deceased shareholder’s estate.
- Promissory note method – Corporate owned life insurance is placed on the life of each shareholder with the corporation named as the beneficiary. In the event that a shareholder dies, the surviving shareholder buys the deceased’s shares from his estate using a promissory note. The life insurance proceeds are paid to the corporation and placed in the capital dividend account. The surviving shareholder receives the proceeds tax-free via a capital dividend, and uses it to pay off his promissory note to the deceased shareholder’s estate.
- Share redemption method – Similar to the promissory note method, corporate owned life insurance is placed on the life of each shareholder with the corporation named as the beneficiary. The life insurance proceeds are also paid to the corporation and placed in the capital dividend account. However, unlike the previous arrangement, the company then uses the proceeds in the capital dividend account to redeem the shares held by the deceased shareholder’s estate. The surviving shareholder is not involved in the transaction, but will end up owning 100% of the company after the process is completed.
While the methods above involve the aftermath of the shares after an owner passes away, similar arrangements can be made for the long-term disability of an owner.
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