Every business owner knows that a continuity plan for that business is imperative. But the way businesses are passed on isn’t exactly simple, especially when you’re dealing with a corporate entity or partnership. One of the most important parts of business continuity is ensuring the right person (or people) get your business interest when you pass away. If you want your business interest to go to a particular person, you might have to provide funds for them to be able to buy that interest. That’s where life insurance comes in.
A life insurance trust can be used to create a business continuity plan, by giving funds to purchase your interest in the business to chosen heirs while keeping these purchase funds out of your estate. Much of this is covered under what’s known as a buy-sell agreement.
A buy-sell agreement is set up ahead of time to determine who will buy your business interest in the event of your retirement, disability, or death. The buy-sell agreement covers who will be allowed to buy the business interest, while life insurance trusts can provide the funding. These agreements can use a number of methods in buying out the business interest, with the two most common being entity purchase agreements and cross-purchase agreements.
An Entity Purchase in Business Continuity Insurance
One of the most common ways that a business can protect itself from the loss of key personnel is with an entity purchase of life insurance. The business buys a policy on the individual’s life and makes itself the beneficiary. When that individual dies, his or her interest is absorbed back into the company. The life insurance allows additional funds to hire new personnel so the business can continue. While a reliable method, there are some things that you need to be aware of in the event of an entity purchase.
This method transfers the ownership to the business, usually to be parsed out among the co-owners as part of a buy-sell agreement. The buy-sell agreement is binding, making it difficult to change. This is why the plan must be checked regularly and updated to ensure it’s still applicable as the business grows and becomes more complex. The business will also need to be the entity to provide the premiums for these life insurance policies and ensure the policies are large enough to cover each involved party’s proportionate ownership amount.
An entity purchase might also be called a stock purchase, and it’s considered one of the simpler business continuation methods because it allows the business to access the cash value of a policy for certain expenses, allowing for more liquidity for funds.
A Cross-Purchase In Business Continuity Insurance
Another business continuation insurance strategy is using cross-purchases of life insurance. While this can be a bit more complex, it can be beneficial in cases of multiple business owners.
A cross-purchase agreement is a buy-sell agreement that’s structured to manage more complicated corporate buyouts or businesses with a significant amount of partners and equity owners. In this case, the involved parties create a binding agreement about how business interest will be purchased by each owner from each owner and the specific formula to be used to determine the cost.
While that formula won’t change, the amount will as the business grows. That’s why life insurance-funded agreements are used. In this case, the individual owners would purchase policies on the others based on the amount that the business interest would cost them in the future. This prevents both the money and the business holdings from going through probate, allowing business, even in a major corporation, to continue as usual.
Because this method keeps the business out of the purchase, treating it as an asset rather than an entity, it’s more expensive for all the individuals involved. The owners have to make premium payments themselves, and there’s the risk that the cash value of the policy will be included in that business owner’s estate.
This is why these policies can be kept within an irrevocable life insurance trust (ILIT). The ILIT bypasses the owner’s estate, allowing the life insurance proceeds to be used for what they were intended, which is the continuation of the business.
Using a life insurance trust can be particularly attractive in the case of a family-owned business, where you might want to pass on the business to your heirs but, at the same time, need to keep the purchase funds outside of your estate. This can ensure that a family business stays within the family, rather than having to liquidate any assets to pay off estate taxes.
The ILIT is a key component of a business continuity plan, but can be a bit complex to set up. If you’re interested in using life insurance as a funding method for business continuity, contact a Howard Kaye advisor by calling 800-DIE-RICH.
