A prudent part of any business plan involves considering how ownership interests are handled
when an owner becomes disabled, passes away or retires. The document that outlines how
this works and the agreements between the owners is called a “buy sell plan.”
The Buy Sell Plan
This legal document sets forth the triggers that cause ownership to change (like death,
disability, and retirement), the timing of the payments for those ownership interests (lump sum
or installment payments), and who has the rights to force other parties to act.
Valuation of the Business
As part of the planning, the owners need to understand what the business is worth today and
how its value will change over time.
There are real dangers to a business if the disability or life buyout agreement is not done well.
Imagine a scenario where your corporate buyout agreement agrees to a valuation of the
business, you fund the current agreement with life and disability insurance for the buyouts, and
six years later the value of the business is 10 times what it was when you agreed to the formula.
The agreement is underfunded by insurance, and now imagine one of the partners becomes
disabled. When you signed the agreement, you would have owed $250,000 to a partner who
became permanently disabled. Now you owe $1.5 million and have only $250,000 of insurance.
This scenario is too common, and one reason why it is very important to work with specialists
for disability and life buyout agreements in partnerships. Consult your business advisers,
accountant, and attorney on all these issues.
The decision is to understand if an owner dies or is disabled, how are the remaining owners
going to pay for the shares of the business. Obviously, it’s important to plan for these
possibilities.
How to pay for the obligations outlined in the buy sell plan
This is referred to as “funding” the plan. The agreement is of no use if there is not a method for
cash to change hands. You can use current cash flow, establish a sinking fund, utilized bank
lending, or secure insurance. Insurance is the most common because it is simple, guaranteed
and is the most inexpensive method to provide funding to meet the payments as outlined in the
buy sell plan. Insurance is an inexpensive way to fund the payments in the event of a death or
disability of an owner.
Just as with life insurance, the disability buy-out policy is a great way to leverage the company
dollar. If you became disabled and the partners were going to buy you out and your share of
the company was worth $500,000, where would the money come from?
Death of an Owner
In the event of a premature term life insurance is the best way (and most common way) to
provides funds to satisfy buy-sell obligations. Term insurance provides a vehicle to use a small
portion of business cash flow to guarantee a large lump sum at the death of an owner.
Disability of an Owner
In the event of a disability, the company would need to buy out the disabled partner for his or
her share of the company. This type of insurance is called “disability buy out” insurance. Many
buy-sell plans require a buy-out take place after the partner has been permanently disabled for
a defined period of time. A common waiting period before the buy-out would occur is usually
a minimum of one year so any policy to fund for this risk has the same waiting period.
Alternatively, some companies opt for an 18- or 24-month waiting period. The buy-out policy
benefit can be paid in a lump sum or monthly over a certain period of time, such as five years.
Just as with life insurance, the disability buy-out policy is a great way to leverage the company
dollar. If you became disabled and the partners were going to buy you out and your share of
the company was worth $500,000, where would the money come from? The most efficient way
to fund this is through the disability policy, using pennies on the dollar to fund the obligation.
You can leverage the company assets by paying for life insurance that will pay your family for
their share of the business. This is the most efficient way to pay for a death buyout. You can use
term life or permanent life insurance. If you only need the pure death benefit for a defined
period of time, not to exceed 30 years, for instance, term life is the best fit for you. However, if
you want the life insurance to extend past a defined number of years, perhaps even after your
interest in the company has ceased, a permanent plan may be the best fit.
The permanent insurance can also be used to enhance benefits to the owners and leverage
premiums in a very tax-efficient manner. The business can fund the plan and simply add the
premiums to the partner's gross income. The net cost effect to the partner is the tax due on the
premium amount paid by the company. The tax-advantaged cash value that builds up in the
permanent policy can be used in the future for almost anything the partner wants: a car,
college funding, a second home, retirement, etc. If done correctly, there would be no tax or
penalty due on the amount withdrawn from the plan.