There are multiple ways you could fund a buy-sell agreement. We will explore 4 methods below:
Life Insurance: A common method of funding buy-sell agreements is taking out a life insurance policy on the present business owner or owners. Following an owner’s death, this common, cost-effective method, makes cash available. Be aware that it is advised that the insured party not have incidents of ownership over a policy on the insured person’s life so as to avoid the estate tax inclusion, under IRC 2042. Clients should always work with their legal and tax advisors during the planning stage. Another reason why life insurance policy may be a proper planning tool for a buy-sell agreement is if the policy has cash value in a permanent life insurance, a buyout of the business after retirement may be possible with those policy funds.
Sinking Funds: In this method of funding buy-sell arrangements, business profits are held back and used to cover the cost of a buy-sell arrangement. However, should an owner become deceased following the implementation of this strategy, then the business cannot accrue the necessary funding to fulfill its redemption obligation.
Installment Purchase: Buy-sell arrangements can also be funded by installment purchases. Bear in mind that this strategy has a major flaw due to its tendency to inhibit cash flow, which can cause dramatic effects if the interest purchased belongs to a majority owner. No cash flow could mean no business.
Borrow Funds: Borrowing funds is always an option when someone owes money, however, as most know, borrowing money comes with its downsides. Obtaining a loan may not be easy for the remaining partners or owners as the business will no longer have a key member of their business. Another cause for concern is if the business is able to acquire a loan for the buy-sell arrangement, future loans, whether for growth or as cash-flow, may prove to be difficult.
It is critical, no matter what method to fund the buy-sell agreement is chosen, be sure to seek the advice of trusted advisors including, but not limited to, CPA’s, Attorney’s, Financial Advisors and Life Insurance Agents.