Buy-Sell Agreements: Rethinking the Role of Life Insurance in 2019 and Beyond
“As appeared in Insurance News Net Magazine February 2019 edition”
For decades Buy-Sell Agreements have paved the way for a natural life insurance sale, but there’s been no better time than right now to bolster your clients’ Buy-Sell Agreements using modern-day life insurance policies.
From a pure policy funding standpoint, even if our business owner clients already have some sort of Buy-Sell Agreement in place, their life insurance policies may be out of alignment for the following reasons:
- Many businesses have increased in value since 2009, and the amount of death benefit originally purchased may no longer be sufficient to cover whatever value or formula is specified in their Buy-Sell Agreement.
- In many cases, business owners now plan to work longer than they had originally intended since retirement accounts and real estate values spent most of the last decade playing catch-up. Therefore, term life insurance policies may be set to lapse before the business owners retire.
Here are 3 compelling reasons to revisit the insurance planning backing their Buy-Sell Agreement agreement:
- Today’s mortality pricing and underwriting standards are more forgiving than ever before (especially for things like controlled blood pressure and cholesterol issues).
- Attractive permanent insurance options and conversion privileges come standard with many of today’s term life insurance products (more to follow on the multiple ways cash value life insurance products can greatly enhance traditional buyouts).
- Most of all, the addition of “living benefits” built into many of today’s life insurance products can provide payouts for chronic/critical illness and injury, and help to fill one of the biggest gaps in most Buy-Sell Agreements.
Of course, many business owners resist the notion of getting any life insurance, much less drafting of a Buy-Sell Agreement. Most would rather go in for a root canal than deal with attorneys and insurance agents.
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Entrepreneurs should understand the only four possible outcomes from having no Buy-Sell Agreement in place or insufficient funding to buy out a deceased partner’s heirs:
- The assets of the business are liquidated in a fire sale, since a substantial chunk of its enterprise value went down with the owner who passed.
- Surviving owners plead with the bank to place debt on the wounded company, so they can buy out the deceased owner’s heirs (good luck).
- The deceased owner’s heirs accept a long-term note for their inherited ownership and hope the company can float years of payments despite just losing a key person.
- The deceased owner’s heirs refuse to release their inherited ownership, and the surviving owners must perpetually share the company’s distributions with them. The heirs may have a legal right to examine the company’s records and even vote with their ownership interest. Regardless, the surviving owners have a fiduciary duty to their new co-owners, even if they can’t ever contribute to the company’s growth.
Without all the bells and whistles of today’s new policies, couldn’t a plain old term policy avert all four of those horrible outcomes when combined with a properly drafted agreement?
YES, and today’s life insurance policies can even take things a step further by helping to protect against disability as well as death.
Let’s face it, those same four grim outcomes are in play if an owner becomes too sick or hurt to work. Isn’t disability much more likely to occur than death? Of course, that’s why disability insurance is significantly more expensive than life insurance, and why many business owners will often opt to roll the dice rather than insure for the risk.
What if their life insurance policy also had “living benefit” provisions in case they were too sick or hurt to ever work again?
But will these living benefit provisions be as comprehensive as a true own-occupation disability policy?
NO, in fact, they may just advance a portion of the death benefit and only for the most severe health conditions.
To be clear, I’m not saying that you should only be recommending one of these new hybrid life insurance policies over a true disability policy. Since a true disability buy-out policy will often have the most comprehensive definition of disability, you should always offer it as an option even if it’s more money than they plan to spend. Then you’ve fulfilled your duty as an advisor offering them education on their options. If they decline a true disability policy, then at least a hybrid life insurance with living benefits is better than nothing to hedge against this serious risk.
Wouldn’t a disabled owner feel much better about accepting a note for his company equity if it came with a hefty down-payment?
Don’t most of your business owner clients have that “I’ll die with my boots on” mentality?
That’s why they may be interested in hedging only for the most extreme scenarios. If these living benefits came bolted onto a life insurance policy for a fraction of the cost, you will have done them, their partners, and their family a great service by helping to shore up this gap in their Buy-Sell Agreements.
Believe it or not, some term life insurance policies even include these living benefits for a very nominal increase in premium over the cheapest term policies. And these same term policies can be converted (without evidence of insurability) to a comparable permanent policy with the same life insurance company anytime throughout the policy’s term.
This term grid below compares the cheapest term insurance (what everyone thinks they want), next to fairly inexpensive term insurance with solid conversion options, and the last column shows convertible term insurance with built-in living benefit protection. Most clients are happy to pay a little extra premium for a lot of extra protection.
I’m not saying that term insurance is necessarily the best solution. However, we know that our business owner clients usually think of insurance as a pure cost eroding their bottom line. That is, until we can educate them properly about the unique wealth-building characteristics of permanent insurance.
Sometimes however, it’s best to start in the quoting arena they understand, and then later educate around the value of permanent insurance throughout the underwriting process. Think about it, it often takes weeks or months to erode their erroneous paradigm around permanent life insurance. If you move too fast or dump too much information all at once, you’re apt to lose their attention completely.
Here are a few compelling reasons to fund a Buy-Sell Agreement using permanent life insurance.
First of all, permanent policies often have more robust living benefit provisions than a comparable-sized term policy. Since disability is such a huge unfunded risk within most Buy-Sell Agreements, this alone is a compelling reason to have at least part of the buy-sell agreement funded by permanent life insurance.
The other big unfunded liability found in most every Buy-Sell Agreement is how to buy out retiring owners who don’t die or become disabled during their working years. Isn’t a normal retirement buy-out the most likely scenario?
There’s no way to insure per say for business owners who prosper throughout their working years and want to monetize their business equity come retirement age. However, there may be no better way for the remaining owners to safely grow their liquid reserves than with permanent life insurance.
The last reason why permanent life insurance should make up some portion of the Buy-Sell Agreement is cash flow management.
Just look inside the major banking institutions where your business owners currently deposit their cash reserves. You’ll find that these big banks often invest billions of their own capital reserves into cash value life insurance on their key executives.
Did these big banks make a mistake?
Did they not read the latest DIY financial blogs?
Did they get swindled for billions of dollars by some slick life insurance agent?
Of course not. Then shouldn’t these same banks recommend to their depositors that they reposition some of their longer-term reserves into life insurance?
That’s why our company’s tagline is “Don’t Do What Banks Say…Do What They Do!”
Banks understand that from a cash-on-cash standpoint there’s no better place to get competitive growth… safely… within a tax-sheltered environment… while maintaining their liquidity… and providing protection on their most valuable assets: key employees. Banks are all about getting multiple bites of the apple from one dollar, and this is just one of the ways they do so.
The cash reserves your entrepreneur clients deposit into banks are like having lazy unproductive employees. Conversely, the cash reserves that big banks park inside performance-based life insurance products are like multitasking superstar employees.
What if you could instruct your entrepreneur clients to multiply their safe reserves by capturing ongoing compounding on their stagnant cash? Most don’t understand the lost opportunity cost of keeping their reserves languishing in low-yielding accounts for decades on end while banks profit healthily.
The lost compounding alone can help to subsidize the buyout of the next retiring partner. Depending on how long the cash value can bake within the policy, sometimes the tax-sheltered growth will far exceed the amount of premiums they paid. By moving cash from one pocket to another over the course of four or more years, these business owners can substantially increase their overall bottom line without adding extra overhead, equipment, risk, etc..
Permanent life insurance is not a black hole for premiums.
Unfortunately, most entrepreneurs feel like the premiums they pay get sucked down a black hole never to return. They perceive that any policy equity is off-limits to them during their lifetime. Help them understand the truth. It’s why billions of dollars of cash value are listed as “life insurance assets” on the public balance sheets of these major banks.
They can tap into that cash value at any time for any reason via loan or withdrawal. Whereas many of your W-2 employee clients may head for the hills when they hear the words “loan” or “borrow,” most entrepreneurs already embrace the concept of using OPM (other people’s money).
A life insurance loan may be the safest and most flexible way to practice OPM. Their full cash value balance continues growing safely as if it never left their policy because… it never leaves their policy!
All life insurance companies contractually agree to provide a private loan against policy equity on a no-questions-asked basis since they’ll be holding the cash value as collateral. Yes, the policyholder will owe interest, but they get to choose if and when they pay it. You see, technically a life insurance loan is against the policy’s death benefit, so the loan isn’t due until death. That’s why there’s no rigid payment structure so long as the cash value exceeds the loan amount. They should responsibly schedule some periodic loan maintenance, but the cash value growth may keep pace with any accruing loan interest or possibly even outrun it.
I’ve found this flexible-lending feature to be incredibly appealing to business owners. They can maintain their place in line on the compound interest curve with their cash value while using policy loans to enhance their most-prized asset, their business.
Currently, certain Indexed Universal Life policies even offer contractually locked loan rates in the 5%-6% range for the life of the policy!
Think interest rates are going up? Try asking a business banker to provide a lifetime rate-lock on a line of credit… Ha!
Business owners really love this concept of locking in their ability to access capital at 5%-6% while still being able to earn double-digit returns on their cash value.
Who Should Own the Policies?
Although it may seem simpler to have the operating company itself own the life insurance policies backing the Buy-Sell Agreement, it may be more tax efficient to have the individual owners take out policies on each other.
If the company itself receives the death benefit and uses the proceeds to buy out the deceased owner’s heirs, the company gets no increase in basis for the ownership it paid for. This type of Buy-Sell agreement is commonly referred to as a “Stock Redemption” plan or agreement. However, since LLC also stands for “Lawyers’ Likely Choice” (kidding not kidding), it’s more appropriate to refer to this structure as an “Entity Redemption” because LLCs are made up of units rather than stock.
On the other hand, in a “Cross Purchase Agreement” the owners personally take out policies on each other. Because the surviving owners would receive the death benefits personally and then use the proceeds to buy the deceased owner’s stock or units, their new basis in the company increases by the amount they paid. Down the road if the company is sold for a capital gain, the amount deemed as basis in their partner’s stock or LLC units would not be taxable.
I’ve found that business owners deem this huge possible tax benefit worth the extra complication unless there are more than three owners. With three owners, six policies are needed (since each owner needs a policy on each other). With four owners, twelve separate life insurance policies are needed. With five owners, twenty policies, and so on.
I usually prefer that any permanent policies be moved off the operating business balance sheet anyway. That’s where most of the risk resides, and the owners are much less likely to be sued personally. Also, in many states, life insurance may be an exempt asset protected from creditors when held personally.
One way to get the best features of both an Entity Redemption and Cross-Purchase Plan is to have the owners set up a separate Buy-Sell LLC that owns one policy on each owner (or possibly two policies on each owner when doing a combination of term and permanent life insurance). The LLC language needs to be structured so that only the surviving owners’ capital accounts receive their proportionate share of any death benefit. Then they will have manufactured the necessary separation to get the benefits of a Cross-Purchase Agreement within the centralized simplicity of an Entity Redemption Plan.
Taking the LLC concept a step further, it can also act as their own private lending or leasing company. Having the separate LLC stockpile cash value and/or purchase expensive equipment using policy loans, which can turbo-charge what would otherwise be stagnant assets.
This separate structure for the assets may also better insulate the owners from lawsuit. In many states, a “charging order” is the only way that a creditor can attach any LLC interests owned by the defendants. This means that someone who has won a lawsuit against our business owner clients would be entitled to any distributions made from their Buy-Sell LLC Lending Company. However, the creditors can’t force the owners to give up assets from within the LLC when a charging order is all they have.
Couldn’t the members of the Buy-Sell LLC vote not to make any distributions for a while? In many cases, wouldn’t that cause the creditor to settle the judgment at a discount or possibly even go away?
There would obviously be additional drafting and filing requirements necessary for this Hybrid LLC Buy-Sell Agreement, but for larger businesses with scale, it’s a small conversation for the amount of efficiency and protection that can be manufactured through proper planning.
Bringing Buy-Sell Agreements to Top of Mind
There’s been no better time than right now to share this thinking with your business owner clients who may need to form or update their Buy-Sell Agreements anyway. There’s always a natural propensity for our clients to do nothing new, but I just shared many compelling catalysts that should help you help them overcome that gravity.
It used to be that life insurance was a “later-product” to benefit somebody else. Nowadays, it can be structured to be a “now-product” to benefit both the insured during their lifetime and their heirs after they pass.
Show your entrepreneurs how this helps protect their most-prized asset, their business. Show them how the multi-faceted hedged benefits are easily worth the cost. Better yet, show them how they can protect themselves while building a tax-favored asset they can use leading up to retirement and beyond.
Advise them like no one else in their world ever has, and you can acquire multiple new entrepreneur clients who will continue to have ongoing and complex needs for your services.