The business itself may also suffer form a supplier’s or creditor’s perception of the value of the deceased person to the success of the business. Key employees may consider the deceased’s death as a reason to move elsewhere. There needs to be continuity and a smooth transition in the business when tragic events such as deaths or disabilities occur. The buy-sell agreement is important to resolve a lot of problems dealing with employees, creditors, suppliers and the deceased person’s family.

Importantly, where will the funds come from to provide continuity and a smooth transition? Everyone is going to die and sometimes it happens totally unexpectedly and at a much younger age when expected. There are no dying rules specific to owners, partners and shareholders. Stuff happens!

A buy-out sell agreement is, essentially, the will for the business and it eliminates a lot of difficulties and heartaches when a key person dies. A plan needs to be in place and a method of funding that plan must also be available.

There are several options for business owners to fund a buy-sell agreement:

• They can wait and see - “I’ll worry about that if and when it happens.” A sole proprietor can say, “I’ll be dead, so no reason for me to worry about it.” Sure! If it is a partnership, the partnership dissolves automatically and, “My partner will do the right thing.” Is that what you want? You can use your personal funds to buy-out your partner’s stock. But what if it comes at a bad time? Your personal stock portfolio is down, you’ve got two children in college, and you’ve had to take less income form the business lately because business has been in a slump. Maybe, after a lengthy probate the corporation can buy the stock and place it into treasury stock, if funds are available.
  But where does this leave the family of the deceased? Would you leave it up to your partners to do the right thing for your family no matter what the personal cost would be to the partner?
• They can borrow funds - obviously, borrowing funds is not an option to a dead sole proprietor. Could a key employee put together the money to purchase the company? Can the surviving partner(s) borrow enough to purchase the assets of the deceased partner? Maybe they can take out a second mortgage on the house? Maybe the lost one is the one depended upon by bankers and suppliers. Maybe the repayment and interest is simply too burdensome.
• They can set-up a savings account within the company - This could be done in anticipation of an event like this happening but, again, if you are a corporation there may be accumulated earnings tax problems and if you are not a corporation, it may be difficult to maintain a savings account or the death may occur prematurely before enough funds are available.
• They can buy life insurance - Let’s look at this from a sole proprietor’s, a partnership’s and a corporation’s perspective.

Sole Proprietor

Unless a sole proprietor (let’s call the person and “owner”) has a family member or a close relative to turn the business over to and feels comfortable the owner’s desires for his/her family members will be served, the options are limited. The business can be closed, it can be sold to an outsider, although small businesses are sometimes difficult to sell, or, if the owner wants his ‘baby’ to continue, it can be sold to one or more competent and faithful employees. The buy-sell agreement to a trusted employee becomes a two-step plan:

1. An agreement is prepared which sets forth the employee’s obligation to buy, the price the employee(s) will pay for the business and the method of payment
2. The employee takes out a life insurance policy on the owner. The employee is the owner of the policy, the person who pays the premiums and the beneficiary.

If the owner dies, the death benefits of the insurance policy would be used to buy the business from the owner's estate.

Partnership

Partnerships are automatically dissolved with the death of one partner; therefore, a buy-sell agreement is very important. In this case, a buy-sell agreement would sell the deceased's interest in the company to the surviving partner(s) at an agreed to price. For partnerships there are two different plans:

• Cross-Purchase Plan- in this plan each partner buys a life insurance policy on each of the other partners. The partnership itself is not a participant in the agreement. Each partner owns, pays the premium payments and is the beneficiary of the insurance policies on the other partners in an amount equal to his share of the purchase price set forth in the buy-sell agreement. The proceeds are used to purchase the partner's business interest from the heir's of the deceased.

The number of policies required for a partnership with multiple partners would be the number of partners X (number of partners-1). For example, a plan for a partnership with three partners would require six separate insurance policies. Each partner would need a policy on each of the other parties.

Let's say a business worth $600,000 is owned by three partners in equal shares. Each partnership would be worth $200,000 and if one of the partners died, the other two partners would have to provide $100,000 each to equally purchase the deceased person's share. Therefore, each partner, in this case, would take out a policy on each of the other two partners in the amount of $100,000 each.

• Entity Plan- in this plan partners enter into an agreement with the partnership who owns, pays the premium payments and is the beneficiary of the policies. When a partner dies, his/her interest is purchased from his/her estate by the partnership at the buy-sell agreement price and the interest is then divided among the surviving partners in proportion to their own interest.

In this case, the $600,000 business discussed above would purchase a $200,000 policy for each of the three partners. If one of the partners dies, the business pays the deceased partner's share from the death benefit of the policy and distributes those shares equally to the two remaining partners. The remaining partners, in this case, would then each own 50% of the business.

Because of origination funding, buy-ins, etc., not all partnerships are owned equally by the partners. In those cases, both the insurance policy's amounts and the benefits distributions would be made on the basis of each partner's proportionate share in the business.

Additionally, none of the premium payments in the above plans are tax deductible; however, the benefits are tax-free.

Closed Corporation

Unlike a partnership, a closed corporation (i.e. a small number of shareholders who run the business) does not cease to exist with the death of one of its shareholders. For closed corporations, there are also two different plans:

• Cross-purchase plan - each stockholder owns, pays for and is the beneficiary of life insurance on the other stockholders in amounts equivalent to his or her share of the purchase price. The corporation is not a party to the agreement. The surviving stockholders purchase the interest of the deceased stockholder as individuals from the estate of the deceased stockholder. This plan is like the cross-purchase plan described in the partnership section above. Obviously, the more shareholders the more difficult this plan becomes.
• Stock redemption plan- the corporation, rather than the stockholders, purchases the insurance policy, pays the insurance premiums and is the beneficiary on the lives of each shareholder. The amount of insurance on each stockholder is equal to the proportionate share of the purchase price. Upon the death of one of the stockholders, the death benefits are paid to the corporation who then buys the deceased's stock from the deceased's estate. Premiums are not taxed deductible but the proceeds are received income tax free.

Any agreements and insurance polices within a business must be integrated with the overall plan and objectives of the business. Careful consideration must be given to the selection of the plan which is right for your business and to the method of funding your plan.

Key-Person Insurance

Key man insurance is life insurance purchased by the company on the life of an employee or employees whose loss would have adverse effects on the company. Employees are valuable assets and the loss of some key employees could significantly impact the profitability, stability and progress of the company.

Often times certain employees or executives are hired because of their own specific expertise they bring to the company. Other employees just seem to represent the persona of the business and have earned the respect, loyalty and credibility of customers, vendors, suppliers, creditors, etc. The loss of those persons could result in some business interruption in some fashion. Small businesses are just that way. Those intangibles are what makes many small companies successful.

The objective of key man insurance is to financially protect the company from adverse impacts if one of those key employees suddenly dies or becomes disabled. The finances available from a key man insurance policy would:

• provide funds to find, recruit and train a replacement
• help replace any profits the company may have earned had the employee not died
• strengthen the company’s working capital and balance sheet to help assure creditors and suppliers about the continuity of the business.

What if the key person is the owner? Key man insurance can be purchased for him also and can resolve the sole proprietor issues discussed in a buy-sell agreement.

There is no easy formula for determining the value of a key employee. Anticipated profit losses, replacement costs, and a compensation-multiple formula, are typical methods of estimating a loss. Good planning should examine all these concepts to develop a program which is right for the company.

The company is the owner of the policy, pays the premiums and is the beneficiary upon death or disability of the key employee. Premiums are not tax-deductible but the death benefits are received tax free.

Clearly, of the four methods of attempting to fund the financial impact of the loss of a key employee (i.e. wait-and-see, borrow funds if you can without that employee, set-up a savings account, or buy insurance), the insurance option is clearly the best option and the most rewarding to the company.

Any agreements and insurance policies within a business must be integrated with the overall plan and objectives of the business. Careful consideration must be given to the selection of the plan which is right for your business and to the method of funding your plan.

Split-Dollar Insurance for Buisness

"Split-Dollar Insurance" is not an insurance policy. It is a method of paying for insurance coverage. A split-dollar plan is an arrangement between two parties that involves "splitting" the premium payments, the cash values, the ownership of the policy, and the death benefits. The arrangement generally involves permanent cash value insurance such as whole life, universal life, variable universal life or a term/whole life blend. An insurance policy with substantial cash value acquired through a split-dollar arrangement can be used by an employee as a source of supplemental retirement income.

By splitting the premiums and ownership with the employee, the employer is essentially guaranteed of receiving the cost of the employer’s contributions to the plan. At the time of death of the insured-employee, the employer will receive an amount equal to the total premiums paid and the beneficiaries designated by the employee will receive the remaining death benefit.

For simplicity sake, let’s look at a situation involving a small business owner and an employee. In this case, the employer takes out a whole life cash value life insurance policy on the employee and agrees to pay the cash value portion of the premium. The employee agrees to pay the remainder of the premium payments (i.e. mortality and expense portion). Upon the death of the insured, the employer would be repaid the amount of funds contributed to the policy and the employee’s designated beneficiary would be paid the remainder of the death benefit.

As an example, a $200,000 whole life insurance policy is purchased for an employee. As part of the agreement, the owner agrees to pay the cash value portion of the premium and at the time of death of the employee, the owner has contributed $43,000 in premiums. Upon the death of the insured employee, the owner would be returned the $43,000 contribution and the employee’s designated beneficiary would be paid $157,000.

Many businesses find a split-dollar arrangement an effective and economical way to obtain and retain key employees by helping them to achieve some sense of security at relatively no cost to the employer and at little cost to the employee. Split-dollar plans can also be very effective where large amounts of insurance are needed by a partner or a business-owner’s estate.

Since these agreements are informal agreements (i.e. not tax qualified benefit plans), the can be discriminatory in terms of employee selection; they do not require IRS qualification; and, the premium payments are not tax deductible. However, the refunded contributions to the employer and the death benefits to the insured’s beneficiaries are tax free.

Split-dollar insurance programs can get very sophisticated and can be used for any number of purposes depending on the type of business (e.g. S-Corp, C-Corp, etc) or the purpose intended (e.g. gifting, estate taxes, switch-dollar, etc.) which are beyond the scope of this discussion.