Structuring Key Person Insurance and Buy-Sell Agreements to Secure Partnership Continuity
I’ve been in meetings before where two partners were discovering together that they essentially don’t have a written partnership agreement! In this case there was one partner who experienced a significant health scare, and another partner who was unable to buy out his partner’s ownership interest because he didn’t have enough cash available to do so. Since the two partners hadn’t planned ahead for the “what ifs”, the business was almost put out of business as a result of a very messy, expensive and unplanned series of events that cost them months of lost growth.
Problem: Buy-sell agreements are often treated by many business owners as legal documents that are “set it and forget it” once they’ve signed them, and many business owners don’t understand that unless they have a source of funding available to them to be able to pay for a buyout of their partner’s interest, that their buy-sell agreement is nothing more than just a piece of paper with no financial value.
Constraints: You will be constrained by cash flow, tax law, the unpredictable nature of human health, as well as maintaining an equitable method of valuation (where valued) of the business so as to not bankrupt the business during the sell-to or buy-back portion of the buy-sell process.
Solution: To ensure that when a triggering event occurs (e.g., the death of a partner), your liquid capital is available and readily accessible, you need to create a strong legal buy-sell agreement with key person insurance buy-sell agreement funding.
Prerequisites and Context
Prerequisites/Contextual Information Required for Implementation: To implement this process you will need to have your current operating agreement, the latest business valuation, and an understanding of your company tax structure (your company could be a C-Corp, S-Corp, or LLC). You should also have a working relationship with a business-oriented insurance broker and a tax attorney that specializes in succession planning.
The Strategic Necessity of Business Continuity Planning
Structuring Key Person Insurance and Buy-Sell Agreement Funding
Evaluating Cross-Purchase vs Entity-Purchase Plans
Funding structures can be set up as cross-purchase or entity purchase plans. In a cross-purchase schedule, each partner has purchased policies for one another. This method provides an advantage from a tax perspective because the surviving partner receives a “stepped-up” tax basis on the stock purchased.
The entity purchase schedule provides a benefit to the owner because the business owns the policy. This structure is easier to administer when there are three or more partners, but it may create complex tax issues based on the form of business entity. For additional information on the structure, refer to the Internal Revenue Service guidelines for Business Succession.
Conducting a Buyout Funding Gap Analysis
At least one time per calendar year perform a buy-out funding gap analysis to determine how the valuation of the business compares to the death benefit values of the insurance policies on the owners. For example, if the valuation of a business increased by 20% compared to the valuation used for the insurance policies, there would be a gap.
Comparison Table: Structural Comparisons
- Cross Purchase: The partners carry a greater administrative burden, but the surviving partner(s) will benefit from a better basis.
- Entity Purchase: The owners carry a lower administrative burden and an easier method to administer when there are multiple partners.
- Cash Flow: The entity purchase uses business funds; the cross purchase uses personal funds.
Selecting the Right Policy: Term Life vs Permanent Insurance Valuation
Cash Value Accumulation Strategy for Future Liquidity
Many business owners automatically select term life because it is more affordable.In case you wish to pursue a cash value accumulation strategy for future liquidity, then a permanent type of insurance will give you enough coverage to act as a “side account” in which your business can borrow from if an owner wishes to take early retirement or for emergency funds.
Insurance Underwriting for Business Owners: Navigating Medical and Financial Disclosures
Underwriting business owner insurance is not done the same as obtaining a personal insurance policy. You will be required to provide extensive financial information.
Required Financial Documentation Checklist:
- Present tax returns for the last three years.
- Present current balance sheet and income statement.
- Present a signed copy of buy-sell agreement.
- Present personal financial statements from all partners.
What Didn’t Work For Me
In my first years of working as a financial consultant, I used a “one size fits all” term insurance policy for a growing technology firm. When their value increased by three times within two years my old policy was very limited. I recognized that insurance is not static; I needed to secure updated underwriting (which was ultimately more i.e. due to the older age/health of the partners) before they had to pay for the first time to obtain a new policy. Be sure to include guaranteed insurability riders.
Integrating Disability Buyout Clauses and Fair Market Value Triggers
Defining Valuation Methods to Prevent Disputes
Changes to Buyout Cla work, they will maintain ownership in their shares. Therefore, you may be left trembling with frustration as a result of being tied to a partner that provides no contribution.
One option is to use a specified formula for fair market value triggers, whether by using a set amount, employing an appraisally based method, or establishing a formula built on EBITDA. You also want to be certain this is a fixed, unchanging value. The industry standards from the AICPA or other industry standards may serve as a strong reference for building a defensible valuation method through use of your industry standards.
The Role of Periodic Appraisals in Maintaining Agreement Relevance
You could end up in court if you do not keep your valuation of “fair market value” updated. To that end, I suggest a formal appraisal be performed at least every 2 years, and preferably annually, to maintain an accurate picture of a business’s “fair market value”.
Edge Case: Addressing Uninsurable Partners and Synthetic Buyout Vehicles
If one of your partners fails their medical examination, you will need to consider a wait and see approach. This is different than just waiting to see what happens. You need to establish an interest-bearing sinking fund and create a deferred or brought-back salary vehicle that you can use as an alternative to the insurance proceeds you would normally have received had the partner passed their medical examination.
Flowchart of a “Wait-and-See” Structure:
- Event trigger – partner dies, or becomes disabled
- Entity would buy partner’s shares (if there is an insurable policy)
- Remaining partners would have option to buy the shares of such partner personally (if there is no insurance policy)
- Option 3: If neither party can purchase, the company must redeem the shares through a structured payout (in the form of an installment plan or through other means).
Best Practices for Periodic Review and Policy Maintenance
Aligning Coverage with Business Growth Cycles
Every time you raise funds or acquire another business, your insurance policy will most likely require changes. Your policy should be treated as a “living” document and updated as needed.
Coordinating Legal Documentation with Insurance Beneficiary Designations
I’ve seen cases where the buy-sell agreement called for a spouse to be the beneficiary of the policy, when the policy’s beneficiary did not name their spouse. There is no right answer in these situations and you should stay very coordinated between your insurance and your legal documentation.
Frequently Asked Questions
How often should we re-evaluate the fair market value triggers in our buy-sell agreement?
At least every two years, and at the time of a major liquidity event and/or significant revenue change.
What happens to the insurance policy if a partner leaves the business before a triggering event occurs?
Typically, the partner that left has the option to buy the policy for its cash surrender value. If they do not, the company can either keep the policy as an asset of the corporation and/or cancel the policy.
Can a single policy cover both death and disability for a key person?
Generally no. You would require a life insurance policy for death and a separate policy to buy out a key person due to disability. Some carriers may provide riders, but coverage may be limited.
