The Use of Life Insurance With Buy-Sell Agreements

It is highly recommended that if at all possible the buy-sell be fully funded from inception. This is because the value of a business interest (and therefore the need for cash to buy that interest) increases because of the real value increases in the interest itself as well as because of inflationary growth. For instance, a business interest worth $500,000 today enjoying a 6 percent real growth and a 4 percent inflationary growth will be worth almost $1,300,000 just ten years from now and over $3,000,000 in twenty years.

Another reason full funding is imperative is that at the death of one owner, the value of the survivor’s stock increases significantly. When there are three or more owners, this entails the purchase of more insurance at future dates.

To help meet future needs, it is strongly suggested that life insurance used to fund a buy-sell be purchased using dividends to buy paid up additions (blocks of additional permanent insurance purchased with no commissions or acquisition cost) and/or one year term insurance (pure term insurance with no commissions or acquisition cost). Alternatively, if universal life insurance is used, then option B (increasing death benefit) can be used to help meet future death benefit needs as the value of the business increases over time).

Split Dollar Arrangement

Essentially, the corporation pays all or the bulk of the premium necessary to finance the insurance that one shareholder buys on the life of another. To secure the repayment of its outlays, the corporation requires the policyowner to collaterally assign his interest to the firm. Under regulations issued in September 2003, the split dollar arrangement must either be a nonequity arrangement that falls within the economic benefit regime (the business is generally entitled to receive back the greater of its premium outlay or the policy cash value) or a loan arrangement that falls within the loan regime (the business is entitled to receive back its premium outlay only). For nonequity split dollar arrangements, the policyowner will either pay or be taxed on the economic benefit cost of the death benefit protection. For loan arrangements, the policyowner must pay or be taxed on market interest rates on the loans. If the policyowner pays or is taxed on less than market interest rates, the split dollar arrangement will be subject to the below market loan rules.

Transfer for Value Problems

A transfer for value problem can exist when a deceased shareholder’s executor or administrator sells policies on the lives of the surviving stockholders. There is both a transfer of a policy and consideration paid for the transfer—the two crucial elements required for the transfer for value rule to be invoked at the death of the insured.

Possible solutions include:

  1. The estate can sell the policies it owns on the lives of surviving shareholders to the corporation, which can then establish a stock redemption plan, Section 303 partial redemption, or a wait and see buy-sell agreement that integrates properly with the existing cross purchase agreement.
  2. The estate can surrender each policy to the insurer for cash. Surviving shareholders can then purchase additional life insurance on each other’s life (assuming they are insurable). Premiums will be higher because the insureds will be older than when the surrendered policies were purchased. Poor health of the survivors or risk-taking avocations may result in rated premiums.
  3. The survivors can purchase the policies on their own lives from the decedent shareholder’s executor and continue them as personal insurance. The proceeds will be received by the insured’s beneficiaries income-tax free because a transfer of a policy to the insured is one of the exceptions to the transfer for value rule.
  4. Perhaps the safest approach, if the circumstances are appropriate, is for a partnership consisting of the surviving partners to purchase the policies.

Using Group Term Insurance

The potential for a transfer for value problem exists where group term life insurance is used to fund a cross purchase agreement.

Example. Marcy S. and Marsha R. are two shareholder executives of the S&R corporation. Each is covered for $500,000 under their company’s group term life plan. Marcy S. names Marsha R. as her beneficiary and Marsha R. names Marcy S. as her beneficiary. Although no money changes hands between the two and even though the policies are term insurance, there is a transfer for valuable consideration. Their reciprocal promises to name each other as beneficiary provides the requisite valuable consideration. At the death of either, proceeds will be subject to ordinary income taxation.

Alternatives to Using Life Insurance

There are three ways other than life insurance to fund a buy-sell: (1) cash; (2) installment payments; and (3) borrowing. Each option presents its own considerations.


If the buy-out is to depend on cash:

  1. How much will be needed?
  2. Will after-tax dollars be kept on hand to finance the purchase?
  3. Will a higher rate of return have to be sacrificed in order to have adequate cash on hand?

Installment Payments

If the buy-out is to depend on installment payments from the buyer to the seller:

Can the decedent-shareholder’s family afford to leave large sums of money at the risk of the business?

Where will the deceased shareholder’s family obtain cash to pay taxes, debts, and other immediate estate settlement costs?

What rate of interest will the decedent’s family need to charge on the unpaid balance?

Will the interest paid by the buyer be deductible?

What will the total cost of payments be in terms of sales necessary to generate the cash to pay both principal and interest?


If the buy-out is to depend on borrowing from a bank or other third party:

  1. Will the firm or the surviving shareholders be able to borrow money after the death or long-term disability of a shareholder-employee?
  2. What rate of interest will be required on the unpaid balance—and will that interest be deductible?
  3. How seriously will the cash drain effect corporate and personal reserves?

In most cases careful consideration of these factors will lead to the conclusion that life insurance is the best option for setting up a buy-sell arrangement.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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