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I.
The problem – What if a
partner dies?
When a partner dies, the business must be liquidated, sold to
heirs of the deceased partner, or reorganized. If a partner
dies, the surviving partner(s) might be left running a business
with a new partner (heir of the deceased partner) who has little
or no experience in the business.
Example: you and a friend open a restaurant. Your friend is
the chef and you run the dining room. Your friend passes away
unexpectedly. Her half of the business goes to her heirs and you
now have her husband as a partner. However, the husband cannot
cook but wants a say in how the restaurant is managed.
The following table shows the
statistical chances of death of one partner prior to the age of
65 for both two-partner and three-partner businesses. Look
particularly at a three-owner business where all partners are
currently age 35. There is more than a 50% chance that one of
the three partners (if all are male) will die prior to reaching
age 65.
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Statistical Chances of Death of One Partner prior to Age
65 |
| Ages |
Male |
Female |
| 55-55 (2
partners) |
20.4% |
13.6% |
| 45-45 (2
partners) |
23.5% |
16.2% |
| 35-35 (2
partners) |
40.4% |
28.8% |
| 55-55-55
(3 partners) |
38.3% |
25.1% |
| 45-45-45
(3 partners) |
49.6% |
35.4% |
| 35-35-35
(3 partners) |
54.0% |
39.9% |
Source: Commissioners 2001
Standard Ordinary Mortality Table
II. The Solution – the Funded Buy/Sell Agreement
What is it? The agreement is a legal
document, usually drawn up by an attorney, which provides,
1)
for the sale by a deceased partner’s estate, of his/her interest
in the business, and for the purchase of such interest by the
partnership, at a fair price, and
2) all or a substantial part
of the funds for the purchase.
Each partner’s interest is
spelled out in the agreement, as is the value of the business –
or a formula to determine the value of the business. At the
death of a partner, the remaining partner(s) buys the deceased
partner’s interest with money obtained from Life insurance
contracts. Life insurance provides the funds to enable the
purchase to proceed.
Example: the restaurant above is valued at $100,000 and each
partner has a 50% interest in the business. At the unexpected
death of the chef, the Buy/Sell Agreement would be activated and
a Life insurance contract owned by the dining room manager on
the chef would pay the surviving partner $50,000, which would
then be used to buy out the heirs of the chef so that the
surviving partner becomes sole proprietor of the restaurant.
Types of Buy/Sell Agreements
Cross-Purchase Plan
This is an agreement between individual partners. The
surviving owners buy the interest of the deceased owner from the
deceased owner’s estate at a price stipulated in the contract.
Life insurance is used to fund the purchase. With this method of
funding, each partner is the applicant, premium payer,
beneficiary and owner of insurance on the life of each other
partner in an amount equal to his/her share of the purchase
price.
Example: Partners A, B, and C own a
business valued at $1,500,000 and they have equal interests in
the business
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Partner A purchases $250,000
of life insurance on Partner B and $250,000 on Partner C |
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•
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Partner B purchases $250,000
of life insurance on Partner A and $250,000 on Partner C |
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Partner C purchases $250,000
of life insurance on Partner A and $250,000 on Partner B |
If Partner A dies, B and C
will each receive $250,000 in life insurance proceeds. They will
turn these proceeds over to A’s estate in exchange for A’s
interest in the business, per the terms of the Buy/Sell
Agreement. The two surviving partners now become equal $750,000
partners in the company.
Note: in this example six Life insurance policies would be
required. This can be expressed in a numeric formula as follows:
N(N-1) equals the number of Life policies required to execute a
Cross-Purchase Buy/Sell Agreement, where N=number of partners.
Redemption (or Entity) Plan
The business itself purchases one Life
policy on each partner equal to each person’s interest in the
business. Using the above example, the business would purchase a
$500,000 Life policy on each of the three partners. The business
is the applicant, premium payer, beneficiary, and owner of
insurance on the life of each partner. When a partner dies, life
insurance proceeds are received by the business and used to
purchase the deceased partner’s interest from his/her estate. The
surviving partners now become 50% owners in the business
($750,000 each).
Wait-and-See Plan
This plan is used when the partners want to use a Buy/Sell
Agreement, but wish to wait until the death of a partner to
decide which plan to use. The Buy/Sell Agreement is still
written, with provisions on valuing the business, but the actual
purchasing method is put on hold.
When Life insurance is to be
used as the funding vehicle, the policies are purchased up
front. If the business purchases the policies on the partners,
then it is set up to fund a Redemption plan.
If a Cross-Purchase
plan is decided upon at the death of a partner, the business can
loan the proceeds to the individual partners to use in buying
the deceased partner’s interest. If the individual partners
purchase life insurance up front, then they are set up to fund a
Cross-Purchase plan.
If a Redemption plan is decided upon at the
death of a partner, then the surviving partners can either loan
the proceeds to the business or invest them as capital
contributions so the business can buy the deceased partner’s
interest.
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Benefits of a Funded Buy/Sell Agreement |
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Benefits to Heirs |
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Creates a qualified
purchaser for the inherited business interest |
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Establishes a fair price for
the business interest |
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Helps set the value of the
business interest for the purpose of estate tax filings,
thereby helping the planning process and possibly
reducing the estate tax obligation |
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Provides cash in exchange
for the business interest – a risky asset for heirs to
hold |
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Reduces the time needed to
administer the estate, thereby reducing estate
administration costs |
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Provides the estate with the
cash needed to meet estate taxes and estate
administration costs |
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Benefits to Business |
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Increases the likelihood
that banks and suppliers will continue to extend credit
lines |
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Helps to assure employees
that the business will continue despite the death of a
key owner-employee |
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Lessens the probability that
customers or clients will seek other suppliers following
death of an owner |
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Benefits to Surviving
Owners |
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Assures the surviving owners
control of the company because the heirs must sell to
the firm and not to outsiders |
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Provides funds to purchase
the business interest held by the heirs |
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Guarantees full management
control by eliminating the possibility that the heirs
will assume management positions for which they are not
qualified |
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Eliminates potential
emotional conflicts between the heirs and the surviving
business owners – conflicts that could impair the
harmonious operation of the company |
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Eliminates pressures on the
surviving owners to help the heirs financially because
they are also family friends, even though such aid might
exacerbate the problems of a business struggling to
adjust to the recent loss of a key owner-employee |
Source: Essentials of Business
Insurance; Glenn E. Stevick, Jr.; Page 5-7
©2003 The American College
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