I am often asked what happens to my partner’s ownership interest in our Company if my partner dies before I do? This is a valid question to think about, especially when you and your partners are starting out. After all, you did not go int business with your partner’s beneficiaries. An option that many people consider is using life insurance proceeds to fund a buy/sell agreement.
Three of the most common ways life insurance proceeds are used to fund the buy/sell are:
1. Redemption. In a redemption, the Company owns the life insurance policies. At an owner’s death, the proceeds are paid to the Company, and the Company uses the proceeds to buy the interests of the deceased owner from his or her personal representative. Once the Company buys the shares, the shares are no longer outstanding and the interests of the remaining owners in the company are increased proportionately. A redemption is simple process which provides centralized management to administer the policies and collect the death benefits. Additionally, if an owner leaves the business, policies on the remaining owners would not be disrupted the way they would in a cross purchase.
2. Cross-Purchase. Under a cross-purchase arrangement, each owner owns a policy of insurance on every other owner, and each surviving owner agrees to buy the deceased owner’s interest directly from the deceased owner’s estate. With multiple owners, a cross purchase lacks a redemption arrangement’s centralized ownership and management of the policies (and its’ proceeds). Rather, since the owners are individually holding policies, the administration of these policies can be much more burdensome for the owners and company.
3. Insurance LLC. While incorporating an insurance LLC into the buy-sell agreement can add cost and complication, it is sometimes a useful option. Typically, an insurance LLC’s ownership should mirror the company’s, and an independent person should serve as the manager. The members of the LLC would make annual capital contributions to pay premiums and at a business owner’s death, the LLC’s manager distributes the proceeds to those business owners who are required to purchase the deceased owner’s interests under the buy-sell agreement when all of the purchase arrangements have been finalized.
Overall, there are many ways to fund a buy/sell agreement and life insurance is only one option. Contact Melody Cobbe and she can discuss this issue with you when drafting your partnership agreement.