Business Succession Planning: How to Use Life Insurance to Fund a Business Buy-Sell Agreement
Major problems can arise when a small business owner dies without a plan in place. This is especially true with an LLC (Limited Liability Company) that has more than one owner. This is because in an LLC, each owner - referred to as a member - owns a percentage of the business.
Before we dive into why this can present problems, let’s get a little background information.
When the LLC is formed, the owners usually fund the business by investing their own money, or by taking out a small business loan. As the business grows over time and becomes profitable, the owners will share in the profits, usually in proportion to each owner's respective investment in the business.
As the revenue and profits grow over time, so too does the value of the business. Whereas the initial value of the business was equal only to the investments made by the owners, the value of a successful business can quickly grow into the millions of dollars, especially when profits and assets such as buildings, equipment, patents and/or trademarks are factored in. And, while it is indeed great for the value of the business to grow, it can also lead to challenges when one of the owners dies and the spouse and/or other heirs of the deceased owner want to collect on their share of the business.
With our background information reviewed, we can begin to see the potential problem. As each LLC member owns a percentage of the business and the dollar amount associated with this percentage grows as the business grows, buying out a deceased member’s percentage (which is typically inherited by the deceased’s family) can become a huge financial burden on the living member.
A Buy-Sell Agreement with Life Insurance can help circumvent this problem.
How It Works:
Each member signs a Buy-Sell Agreement upon starting the business. This states that upon the death of either member, the business will be appraised and the surviving member will have the first opportunity to buy the business.
Each member takes a life insurance policy on the other, increasing the policy’s value as the business grows. The life insurance proceeds on the deceased owner's life will then cover most, if not all, of the purchase price of the business.
In our example, and for many small business owners, a Buy-Sell Agreement funded by life insurance is a great way to protect the surviving owner's interest in the business, as well as a great way to protect the family of the deceased owner.