Many people wonder why they should worry about the “family business” when the sole proprietor dies. Typically, when the sole owner dies, the business will not continue leaving those who are dependent on the income from the business without many options. Therefore, a buy-sell agreement funded with life insurance provides the liquid assets to the heirs and family members giving them more options.
The Mechanics of an Insured Buy-Sell Plan
A cost-effective and efficient process of delivering the cash necessary to fulfill the sale of a business at the death of the sole proprietor is a buy-sell plan funded with life insurance. There are three steps in an insured stock redemption buy-sell plan: a buy-sell agreement, premiums for insurance on a sole proprietor’s life, and a life insurance policy.
- Buy-Sell Agreement – Beginning with a sole proprietor and purchaser, a buy-sell agreement is entered into in which the purchaser agrees to buy and the sole proprietor agrees to sell a business for a predetermined agreed price.
- Premiums for Insurance on a Sole Proprietor’s Life – The purchaser then buys life insurance on the sole proprietor’s life that will be sufficient to cover the purchase price of the business and pay the premiums.
- Life Insurance Policy – This policy on the sole proprietor’s life is now owned by the beneficiary who is also the purchaser of the business.
Once the sole proprietor has died, the final three steps of the buy-sell plan are executed: income tax-free death benefit, business interest/purchase price, and settlement and disbursement of funds.
- Income Tax-Free Death Benefit – Upon the sole proprietor’s death, the death benefit from the life insurance policy is received income tax free by the policy owner who is also the beneficiary and purchaser of the sole proprietorship.
- Business interest/Purchase Price – The beneficiary then uses the proceeds of the life insurance policy to purchase the business interest from the estate. The purchase price is agreed upon before in the buy-sell agreement ensuring that the death benefit is enough to cover the purchase price.
- Settlement and Disbursement of Funds – Once the estate is settled, the administrator or executor distributes the balance of the estate to the heirs.
Other Features of an Insured Buy-Sell Plan
In addition to providing a source of funding after the sole proprietor’s death, a variety of other features are found in an insured buy-sell plan.
- Prompt and Certain Payment – Because life insurance proceeds are not subject to the probate process which can be time consuming and expensive, they are immediately available for beneficiaries to use for the purchase of a sole proprietorship.
- Creating a Source of Cash – Since the sole proprietor’s death often creates the need for cash, a life insurance death benefit provides a source of cash. A need for cash to purchase the sole proprietorship arises at the uncertain time of the death of the sole proprietor.
- Tax-Free Gains – If the death benefit is more than the total premiums paid, the gain is often free from income tax. For example, if the amount of premiums paid at the time of the sole proprietor’s death total $50,000 and the death benefit is $1,000,000 then $950,000 is received income tax-free. This can result in hundreds of thousands of dollars saved.
- Financing – Problems associated with other methods of financing and purchasing a sole proprietorship at the time of death are avoided with life insurance.
- Retirement and Disability – If the sole proprietor becomes disabled or retires, the cash value in the life insurance policy can be used to help purchase the sole proprietorship. Note that withdrawals and loans reduce the overall death benefit and cash value available for use after the death of the sole proprietor.
Since many sole proprietorships involve knowledge and nuances associated with the business only the sole proprietor understands, once the sole proprietor dies, family members and heirs need time to find a suitable purchaser for the business. Purchasing life insurance also helps family member avoid potential “fire sales” that leave family members selling the business for pennies on the dollar.
If a sole proprietor is the primary bread winner of the household, it is vital to purchase life insurance as soon as possible. Life insurance should be at the top of the list for any sole proprietor, especially if this is the only income for the family.
The Advantages of a Buy-Sell Agreement
Life insurance provides many advantages to a buy-sell agreement:
- Continuity of the business by providing any remaining owners or family members with enough cash to purchase the deceased owner’s shares.
- In case of disability or death, income is provided for the deceased owner’s family or heirs.
- The provision of fast access to liquid assets that will keep the family or heirs enough time to pay creditors and sell the business.
- The proceeds from a life insurance death benefit are typically income tax free.
- Decrease the chance that there will be a credit risk because a succession plan is firmly in place.
A formula is used to determine the amount of life insurance a sole proprietor needs to fund a buy-sell agreement. The percentage ownership of the proposed insured, which is 100% of a sole proprietorship, multiplied by the fair market value of the business with a modest growth factor addedintoo the product. Consulting with a knowledgeable life insurance expert can ensure that enough money is taken out on a life insurance policy.
Knowing that the plan that is in place is the best and most resourceful use of funds gives many business owners a great peace of mind. Ensuring that family members are taken care of after a sole proprietor’s death is priceless.