Buy-Sell Policies - Insurance Breakdown
Andy and Ben are partners in a company called Vanilla Inc. Both men are married 30-year-olds in excellent health. They are not currently planning to sell the business so the question of the current “value” of the business is not one they have fully addressed. Each partner makes $100,000 yearly. The IRS would use a simple formula of 10 times net income to place a value on the business, which would be $2 million (10 x $100,000per year income each). Thus, for this case study we will assume the value of their business is $2 million. The fixed overhead of Vanilla Inc is $60,000 per year in rent, advertising, office, etc. Andy and Ben expect their business to last for at least 30 years. Of the two primary aspects of Vanilla Inc, Andy is the manager of the business and Ben is the salesman for their product.
Risk #1: Ben or Andy dies. Andy or Ben is now in business with their deceased partner’s wife. Neither of them has the experience, nor the interest in filling their husbands position.
A Buy-Sell Agreement funded by life insurance would be appropriate. If one of the partners should die, the money from the life insurance policy would provide the capital for the remaining partner to purchase the deceased’s wife’s portion of the company. The wife wouldn’t have to go through the process of finding a buyer for her newly inherited share of the business and a purchase price would have already been established. There are clear cut tax reasons for the policies not to be owned by Vanilla Inc. See page 3 for detailed explanation. This policy works best when the partners own life insurance on each other.
There is a second often overlooked aspect of the buy-sell transaction. It is possible that Andy (or Ben) inherits Ben’s (or Andy’s) half of the company after one of these events and is now the sole owner but does not have enough operating capital to make it through the crisis.
A Key Man Life Insurance Policy provides the operating capital to keep the business functioning for a period of time. Perhaps the remaining partner would need to hire someone new to take the place of the former partner to keep the business running. The remaining partner might decide to sell the business. , may find a new partner, or something else. No matter what, it doesn’t make sense for him to own the business without a survival plan and the cash to carry it out. The policy is owned by the business. The premium is a business expense. It pays a lump sum to the business if the insured dies.
A Catastrophic Disability Insurance policy would provide funds to survive financially. Because they are very young, this type of plan is very inexpensive- $825 each year per couple, or just $517 a year for Ben or Andy. Premiums are tax deductible and benefits are not taxable.
Ben and Andy could also consider a lump sum buy-out. The Classic Disability Buy-Out insurance provides funds for the financial survival of the disabled partner. That takes care of the business, but what about the partner who is no longer employable? He and his wife will need some form of income; the funds from the company will eventually run out. Here, Disability Income Insurance is recommended. This plan provides a monthly benefit that pays up until retirement age.
Risk #3: Ben or Andy is moderately disabled. He will be able to return to work eventually, but is unavailable in the meantime. The company is severely hampered in its ability to earn money yet the overhead costs will continue.
A Disability Business Overhead Expense insurance plan provides the income to pay business expenses if one partner is disabled. Owned and paid for by the company, the company would receive benefits. Vanilla Inc. would be granted an income of $5,000 per month for two years.
Andy and Ben knew all along that their families and future are a top priority. Ultimately they realized that owning insurance was essential to them as it secured the financial futures of their families and their company.
Purpose of Private Ownership of Policies in Buy-Sell:
Ben and Andy want Vanilla Inc to own the life insurance policies as a business expense. If one of them died, the business would buy the shares from the deceased partner’s spouse. This sounds great in theory but has a fatal flaw. When the remaining partner eventually sells the business he will pay capital gains on the $1million since the company assets grew by receiving a $1 million tax-free insurance payment. It is much better for each partner to own a policy on the other paid for with tax dollars. In practice, many companies pay for these policies with company funds. The accountants make sure these payments are expensed as income to the partners.