Small business owners are essential to the success of the business. But what happens when one of the owners passes away? Often the death of a business owner can lead to disruption of the company’s operations—or worse. A buy/sell arrangement, properly funded with life insurance, can help protect the business in the event of the death of an owner.

How this plan works

There are 2 typical structures to a buy/sell arrangement: cross-purchase and entity redemption.

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Under a cross-purchase arrangement, each owner purchases a life insurance policy on the other owner(s). If an owner/insured dies, the surviving owner(s) uses the death benefit to buy the deceased’s share of the business.

Diagram of how a cross-purchase arrangement works during the lifetimes of the co-owners of the business; description above

Diagram of how a cross-purchase arrangement works upon the retirements of the co-owners of the business; description below

Upon retirement, A takes his or her respective policy and B does the same.

If at retirement the insureds “exchange” the policies, there may be tax implications. The taxable amount is equal to the excess of the value of the contract received over the adjusted basis in the contract.

Also, once the policies are exchanged, Insured A no longer has an interest in Insured B’s policy, and Insured B no longer has any interest in Insured A’s policy.

Diagram of how a cross-purchase arrangement works upon the deaths of the co-owners of the business; description below

Assuming the policies were exchanged upon the co-owners' retirements, when Owner/Insured A dies, his or her beneficiaries receive the death benefit from Owner/Insured A’s life insurance policy.

Similarly, when Owner/Insured B dies, their beneficiaries receive the death benefit from their life insurance policy.

Under an entity redemption arrangement, each owner enters into an agreement with the business for the sale of his or her shares to the business. The business purchases separate life insurance policies on the lives of the owners, pays the premiums, and is the owner and beneficiary.

Diagram of how an entity redemption arrangement works during the lifetimes of the co-owners of the business; description above

Diagram of how an entity redemption arrangement works upon the retirements of the co-owners of the business; description below

Upon retirement, there are no changes to the policies at this time. The arrangement continues to stay in force until the death of one of the owners/insureds.

Diagram of how an entity redemption arrangement works upon the death of one of the co-owners of the business; description below

When an owner/insured person dies, his or her shares of the company stock will pass on to the designated beneficiary or estate, and the company may purchase them with proceeds from the life insurance policy.

Potential benefits of a buy/sell arrangement

  • It provides for an equitable and orderly transfer of the business as an asset
  • The arrangement may offer capital gains tax and estate tax advantages to the business owner
  • The deceased owner’s heirs will not be forced to sell the business to general cash and will have a guaranteed buyer for an asset they may have no interest or experience in managing
  • Business owners have the opportunity to buy company shares they may not have been able to afford otherwise within the existing ownership group
  • The arrangement will provide all relevant details pertaining to price, circumstances for sale and potential buyers
  • The remaining owners are assured that the deceased’s share of the business will not pass to someone unsuitable
  • It provides continuity and security for employees, customers, creditors and suppliers of the business

Funding the buy/sell arrangement

Another important component of the agreement is how it’s funded, to ensure that the business or heirs have enough money to complete the sale. Without adequate funding in place, the business runs the risk of not having the money to execute the agreement.

There are 2 ways to fund a buy/sell arrangement, either with an insurance policy or by utilizing non-insurance tools:

Insurance funding options

  • Life insurance
  • Disability insurance

Non-insurance funding options

  • Cash
  • Borrowings
  • Installment payments
  • Private annuity
  • Stock redemption
  • Sale-leaseback
  • Appreciated property bailout
  • Deferred compensation

Choosing the appropriate funding method

Many factors may influence the choice of the funding method, including:

  • Business structure, size and tax bracket
  • Number of owners, their ages and tax brackets
  • Levels of cash or credit readily available to the owners
  • Type of buy/sell agreement

Funding method selection is an important decision, since it can also impact implementation costs and tax treatment of the business transaction. At Nationwide, we have specialists to help you understand the implications of each method and help choose the right one for your client’s unique situation. 

Resources

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As situations change, so will the business's life insurance needs. Care should be taken to ensure these strategies and products are suitable for the business's and the client's long-term goals. Weigh the business's objectives, time horizon and risk tolerance as well as any associated costs before investing. Also, be aware that market volatility can lead to the possibility of the need for additional premium in the policy. Variable life insurance has fees and charges associated with it, which include costs of insurance, underlying fund expenses and administration fees. Investing involves risk, including possible loss of principal. Nationwide and its representatives do not give legal or tax advice. An attorney or tax advisor should be consulted for answers to specific questions.

Variable life insurance has fees and charges associated with it that include costs of insurance that vary with such characteristics of the insured as gender, health and age, underlying fund charges and expenses, and additional charges for riders that customize a policy to fit their individual needs. Variable products are sold by prospectus. You can obtain the product prospectus and underlying fund prospectuses by writing to Nationwide Life Insurance Company, P.O. Box 182021, Columbus, OH 43218-2021. Before you invest, you should read the prospectus carefully and consider investment objectives, risks, charges and expenses. The product prospectus and underlying fund prospectus contain this and other important information.

Loans and withdrawals will reduce the death benefit. Most distributions will be taxed on a first-in/first-out basis, as long as the contract is not a modified endowment contract (MEC) according to Section 7702A of the Internal Revenue Code. Loans from a MEC are generally taxable and subject to a 10% tax penalty if taken before age 59 1/2. If the policy lapses with a loan outstanding, it will be treated as a distribution and some or all of the amount may be taxable.

Guarantees and protections are subject to Nationwide's claims-paying ability. They do not apply to the investment performance or safety of the underlying investment options.

Investment products are not FDIC-insured, may lose value and have no bank guarantee.

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