A recent study from Nationwide shows three in five small businesses do not have a business succession plan in place, meaning they are sorely unprepared in the event something happens to one of the owners. The fact that the personal wealth of many small business owners is intricately tied with their underlying business only serves to compound the problem. Without a proper plan in place, the risks to the business and the family are considerable.

We regularly counsel our small business clients about the importance of implementing a buy-sell agreement. This legally binding arrangement between co-owners of a business determines what happens if a co-owner dies or unexpectedly has to leave the business. To ensure the identified buyer will be able to comply with the terms, it’s most appropriate for funding arrangements to be made in advance.

Although there are several ways to fund a buy-sell agreement, we strongly recommend using life insurance for this purpose. One advantage is that life insurance provides a lump sum of cash that is usually paid quickly upon an owner’s death. What’s more, life insurance proceeds are typically income tax free, though the alternative minimum tax could apply for a C-corporation.

There are different types of buy-sell agreements and structure and taxation considerations are often state-specific, so it’s very important to work with competent financial and legal advisors to ensure you are adequately protected. Even so, it’s a good idea to have a basic understanding of the most common options before starting these discussions.

One popular way to fund a buy-sell agreement with life insurance is known as a cross purchase agreement. This is most appropriate for a small company with four owners or less—with myriad owners it can be too complicated. In this type of agreement, each owner buys an individual policy on each of his partners. The amount of life insurance is equal to each owner’s respective share of the net worth of the business.

By contrast, in an entity purchase buy-sell agreement, the business itself buys separate life insurance policies for each of the co-owners. The business generally pays the annual premiums and is the owner and beneficiary of the policies. There are also hybrid agreements that combine features from both models.

The amount of insurance coverage on your life should equal the value of your ownership interest, but remember the value of the business is likely to shift over time. To account for this, the buy-sell agreement should specify what happens if the insurance proceeds are less than the value of an owner’s business interest. Conversely, the agreement should stipulate what happens if the insurance proceeds exceed the value of the owner’s business interest.

Certainly there are many particulars when it comes to providing adequate coverage within a buy-sell agreement. At Anderson Retirement Solutions, we can help advise you on your insurance needs to help prepare you, your business, and your family for a financially secure future. Please don’t hesitate to contact us at 888.473.6931 to discuss how life insurance can fit into your overall business plan.