In many cases, insurance policies on
the lives of one or more shareholders can provide some or all of the
cash resources needed to implement the buy-sell plan at a
While there is a real cost to using life insurance, the alternatives
may be more costly. Funding a purchase in the absence of insurance can
cash-strap your company or force it to take on major debt.
a buyout is triggered by an event other than death, installment
payments may be advisable. This allows the buyer to secure financing
or fund the buyout through company earnings.
events besides death are disability and employment termination, but
others also may be included in the agreement. For example, an act that
discredits the company and may result in felony conviction, such as
embezzlement or fraud, may be a triggering event. In fact, some
buy-sell agreements have "bad boy" clauses which, when triggered,
establish a low buyout price.
For buyouts triggered by death,
there are two basic types of buy-sell agreements: the stock-redemption
agreement and the cross-purchase agreement. Variations and mixes of
these arrangements may be necessary to accomplish shareholder
In a typical stock
redemption arrangement, the business owns insurance policies on the
lives of each shareholder, and the shareholders enter into an
agreement with the business. For example, Lee, Pat and Chris who are
equal shareholders in LPC, Inc. entered into the following agreement
with the company:
On Lee's death, LPC collects life insurance
proceeds and uses them to buy Lee's stock from his estate. Lee's
estate now has liquidity, and Pat and Chris each owns 50% of LPC. Here
are some important considerations:
● One policy is
generally needed for each shareholder (first-to-die policies are
available to insure two or more lives).
● The business
owns, pays for and controls the policies.
policies are subject to the claims of the business's creditors.
● Because the business is the purchaser of the decedent's
shares, the remaining shareholders do not get a step-up in their tax
basis as a result of the purchase.
● Dividend treatment
can result from stock redemption in a family business because of
family attribution rules, unless specific conditions are met.
● Alternative minimum tax may apply for other than a "small business"
Cross purchase agreements
In a typical cross-purchase agreement, the business is not directly
involved. Each shareholder buys a policy on the life of every other
shareholder, and all shareholders enter into a purchase agreement.
Using the same example as before, Lee would own one policy on Pat
and one on Chris. Pat would own one policy on Lee and one on Chris.
And Chris would own one policy on Lee and one on Pat. On Lee's death,
Pat and Chris would use the proceeds from their policies on Lee to
each buy 50% of Lee's stock from Lee's estate. Again, the estate now
has liquidity, and Pat and Chris each owns 50% of LPC. Again, here are
some important considerations:
● Multiple policies are
needed. The total number needed is equal to n(n-1), where n equals the
number of shareholders (e.g., six separate policies are needed for
Lee, Pat and Chris).
● The shareholders own, pay for
and control the policies.
● The policies are subject to
the claims of the owning shareholders' creditors.
Each purchasing shareholder receives a step-up in basis for the
● No dividend is issued on the sale
because family attribution rules do not apply.
alternative minimum tax is incurred because life insurance proceeds
are not paid to the corporation.
Whether you should use a
stock-redemption or a cross-purchase agreement depends on many
factors, including overall premium expense, sources of funds to pay
premiums, enforcement of the agreement, the importance of step-up in
basis, perceived simplicity, and the shareholders' primary
Another consideration, at least in connection
with a redemption arrangement, is whether the life insurance should be
reflected in the purchase price of the stock. In most cases, the cash
value of the policies, not the death proceeds, are considered part of
the business's assets. .