There are economic benefits in funding a formal buy-sell agreement with life insurance in the event of a business owner's death. But the implementation is often deferred because of the cost of paying premiums for each owner.
Unfortunately, there is always a more important perceived need for the money, rather than paying the insurance premiums. As a further deterrent, these premiums are usually paid with after-tax dollars.
Using a profit-sharing account to fund a buy-sell agreement offers a tax-efficient advantage for small business owners.
This article will outline a technique that will pay for the life insurance premiums on two owners that will guarantee the sale of the business should one of the owners die. The buy-sell agreement is funded using the proceeds of a life insurance contract, owned by a profit-sharing plan, and paid for with tax-deductible dollars.
The simple technique is to use the assets in a businesss qualified profit-sharing plan as a source of the premiums to fund a cross-purchase buy-sell arrangement. This permits such otherwise unavailable funds to solve both a business and a personal need.
Under most small business profit-sharing plans, participants may direct that personal life insurance be purchased to benefit their families. The insurance premium is paid out of a portion of their account, up to certain "incidental limits." However, this same privilege may be utilized in the context of acquiring a life insurance contract on the life of another stockholder or partner where the participant has an insurable interest.
Lets look at an example: Two owners of a business, Pat and Tracy, each own 50% of their business. They agree on a $300,000 sale price for their respective ownership in the business should either of them die. They sign a buy-sell agreement putting this in writing- this is all done entirely outside of the profit-sharing plan.
Their profit-sharing plan is several years old; they each have an accumulated account balance, and are making new contributions each year. This plan must contain a provision that gives each participant the authority to direct the investments in their own account.
Pat directs the plan trustee to buy a $300,000 policy on Tracy. The named beneficiary of the proceeds under this policy is Pats individual profit-sharing account. Tracy reciprocates and directs the trustee to buy a similar $300,000 policy on Pats life. The named beneficiary for this policy is Tracys individual profit-sharing account.
Each year premiums are paid by the plan trustee from each owners respective account. The insurance premium is based on the age of each insured and each owner must include as taxable income the "cost of the economic benefit" of the pure amount at risk for the respective insured.
At the death of one of the owners, the surviving owners account will be paid the death proceeds from the insurer. The pure protection amount of these death proceeds is income-tax-free under IRC 101(a) when distributed to the surviving owner. Any cash value portion is taxable, less recovery of basis for prior aggregate economic benefit amounts previously taxed to the surviving participant owner.
So, how does the Buy-Sell work? If Pat dies, Tracys account will receive $300,000 in death proceeds. Tracy then takes a distribution from her account and completes the terms of the agreement, buying Pats ownership interest from his survivors.
At Pats death, the balance in his account is distributed to Pats beneficiaries. This account also contains the policy owned on Tracys life and will be cashed in or sold to Tracy as personal insurance.
