How buy-sell agreements get funded

If you own a business with partners, you've likely thought about what would happen if one of you left. A buy-sell agreement puts that plan in writing.

But a plan on paper isn't enough on its own. Someone needs the money to actually buy the departing owner's share.

What a buy-sell agreement does

A buy-sell agreement is a legal contract between business owners. It sets the rules for what happens to an owner's share if certain events happen.

Common trigger events include:

• The death of an owner.
• A disability.
• Retirement.
• Divorce.

The agreement often explains who can buy the share and how the price is set. Your attorney drafts the agreement to fit your business.

Two common structures

Buy-sell agreements usually follow one of two basic designs. Each one affects who buys the share and who owns any insurance used to fund it.

• Cross-purchase. The remaining owners buy the departing owner's share directly. Each owner usually holds coverage on the others, so the number of policies grows as owners are added.
• Entity purchase (or redemption). The business itself buys back the share. The business usually owns the coverage.

The two designs can lead to very different tax and estate results. That's an important question for your CPA and attorney.

Common ways to fund the buyout

Once you know who buys and at what price, the next question is where the money comes from. Here are the most common options.

• Cash. The business or owners pay from money on hand. Building up enough can tie up funds the business might use elsewhere.
• Borrowing. A loan can cover the purchase. But lenders may be cautious after a key owner leaves, and they may want collateral.
• Payments over time. The buyer pays the departing owner or their family in installments. This can strain cash flow and leave the family waiting.
• Life insurance. Policies on each owner can pay a death benefit when it's needed. This is a widely used way to fund the death part of an agreement.
• Disability buyout insurance. This coverage is meant to help fund a buyout of a disabled owner. The insurer decides whether the policy's definition of disability is met.

A business may use more than one of these. For example, insurance might cover a death, while cash or payments cover a retirement.

Why life insurance is often part of the plan

A death is sudden, and the family of the owner who passed may need money soon. Life insurance can provide funds at that moment, without draining the business.

There are a few things to keep in mind:

• Tax treatment depends on how the policies are owned and set up.
• Employer-owned policies have notice-and-consent rules to follow before coverage is issued.
• Coverage amounts should be reviewed as the business value changes.

Owners also choose between term and permanent coverage, which our guide to term vs. whole life explains. If the business also relies on a non-owner, see what key person insurance is.

Our team helps with the insurance side. We work alongside your attorney and CPA so the agreement and the policies line up.

Common questions

How often should a buy-sell agreement be reviewed?

There's no set rule, but a regular review and a check after big changes can help. A price set years ago may no longer fit, and coverage may fall short of the buyout cost.

Who owns the life insurance in a buy-sell agreement?

It depends on the design. In a cross-purchase, owners usually hold policies on each other, and in an entity purchase, the business usually owns them.

Bottom line

A buy-sell agreement protects owners and their families, but only if it's funded. Thinking about the money ahead of time can make a hard moment a little easier.

Talk with your attorney and CPA about the agreement itself. For help with the insurance side, visit our business owner solutions page.

Have questions about your situation? Book a complimentary call with our team.

This article is for general education only and isn't financial, tax or legal advice. Product features vary by carrier and state. Talk with a licensed professional about your situation.