With baby boomers moving deeper into retirement, many are preparing to pass on their businesses to heirs or co-owners through buy-sell agreements funded with the help of life insurance policies.
The first rule to drafting buy-sell agreements is to avoid mistakes. But that’s not as easy as it sounds, said Terri Getman, an expert in using life insurance to fund buy-sell agreements.
Hammering out an up-to-date buy-sell agreement requires three parties - the insurance agent, the attorney and the accountant - to remain on the same page at every turn, Getman said. But, in her experience, each of those three parties goes their separate ways, only to meet again briefly and infrequently.
“What they need is a case manager to manage them all; they go off in all directions,” Getman said in an interview with InsuranceNewsNet. Getman is business development director with Diversified Brokerage Services Inc. in Minneapolis.
Buy-sell experts say one of the most important issues is making sure the business valuation is accurate.
Many buy-sell agreements refer to a fixed-dollar amount or a formula to determine the purchase price. This would not be a problem, except that the purchase price often is determined shortly after a business is formed.
A business that has crested the 50-year mark or is in its second or third generation of ownership is likely to be far more valuable than the fixed price that was set for it many years ago. Buyers and sellers should agree on a price before the sale.
“Surviving owners may find themselves negotiating with a surviving spouse in dire need of cash or an ex-spouse’s divorce lawyer,” according to a “Cannon Insights” white paper on avoiding common mistakes in buy-sell agreements.
A price negotiated under those circumstances will not be the price the buyers and sellers would have agreed upon if both parties were on equal footing, the paper published in 2011 by the Cannon Financial Institute indicates.
Where a buy-sell agreement stipulates that a formula determines the value of a business and company-owned life insurance (COLI) policies list the company as a beneficiary, the buy-sell agreement should be clear about the proceeds from the life insurance policy’s death benefit.
Are the proceeds from the death benefit considered cash or cash equivalents for the purposes of the valuation formula, asks a recent best practices paper issued by The Principal Financial Group.
COLI may be excluded from the value of the business. This is because a buy-sell agreement can be structured to lock-in the value of the business for estate tax purposes without counting the life insurance acquired for the purposes of funding the buy-sell transaction, according to The Principal.
The company’s best practices guide derived from an analysis of more than 1,000 buy-sell agreements drafted over the last several years.
A second mistake people make is to come up short with financing of the purchase price, Getman said. “Cuteness in design always creates a problem with an underwriter,” she said.
“Without proper funding, the survivors or the business itself may be unable to meet commitments under the buy-sell agreement, leaving a deceased owner’s heirs or a disabled owner in the lurch,” according to Cannon Insights.
Face amounts of life insurance or lump sum payouts from a disability insurance policy may have been adequate at the time the buy-sell agreement was executed. However, subsequent growth in the business may have created a payout shortfall. In addition, buying more life or disability coverage could be subject to medical underwriting, which carriers may decline if one or more business owners find themselves in failing health.
Experts also point to the improper ownership and beneficiary designations as a sticking point. An entity-purchase or a cross-purchase funding structure for buy-sell agreement can both lead to potentially poor tax outcomes.
In the case of entity purchases, in which the business owns a policy on each business owner, experts at The Principal say that an “undocumented endorsement or split dollar plan,” or a dividend causes the death benefit to be taxed as ordinary income.
For cross-purchase buy-sell agreements in which each insured owns a policy on their own life, naming the other owner or owners as a beneficiary, tax issues arise through the “transfer for value” when an owner dies. This triggers taxes on the death benefit, according to The Principal’s brief.
Why are some of these issues coming up with buy-sell deals?
Getman said that as veteran life-insurance-only agents retire or leave the industry, fewer advisors are around to approach the buy-sell transaction expertise from the life insurance perspective, leaving the accountants to make the decisions.
Accountants and business owners often approach buy-sell transactions with the “overriding desire” for a tax deduction, which is a mistake, she said.
“The old insurance guy is now the investment guy and insurance on the sideline,” Getman said.
InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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