For many business owners, their business represents their most significant asset, making it essential to protect its value for the benefit of their family. A properly crafted estate plan can accomplish that by minimizing estate costs and taxes when the asset is transferred to the surviving family. However, business owners who share ownership with partners must take the additional, crucial step of ensuring their business continues after the death of a partner.

The Costly Consequences of Not Having a Business Continuation Plan

Without a business continuation plan, your deceased partner’s spouse or children may show up asking which office is theirs-which could be a nightmare in some cases. If there’s no arrangement or funds available to buy out the interests of the deceased partner’s estate, the business risks dissolution. Preparing for the continuation of their business becomes a critical estate planning issue for business partners hoping to pass the value of their business interests to their families.

Central to a business continuation plan is a buy-sell agreement, a legal arrangement specifying how, when, how much, and to whom a deceased partner’s business interests will be transferred. However, the arrangement becomes moot if the surviving partners don’t have the funds to buy out the deceased partner’s family or estate.

That’s why, with most buy-sell agreements, life insurance is purchased on the lives of each partner. While partners can use their own capital for a buyout if they have it, life insurance is a low-cost way to guarantee the funding of the agreement while allowing the partners and business to hold on to their capital.

How Buy-Sell Agreements Work

When crafting a buy-sell agreement, the primary issue is determining which type is most suitable for the business and its partners. That will also dictate the type of life insurance arrangement most effective at facilitating agreement.

The two most common types of buy-sell agreements used by businesses with multiple partners are a cross-purchase agreement or stock purchase agreement, also known as an entity plan.

Cross-Purchase Agreement

A cross-purchase agreement is a better option for businesses with three or fewer owners, typically in the form of a partnership. Here’s how it works:

• A legal agreement is created binding each partner to purchase a proportionate share of the other partners upon their death at an agreed-upon price.
• The partners purchase a life insurance policy on the lives of the other partners, naming themselves as the beneficiary.
• The tax code (Section 162) allows the business to bonus owners the amount of life insurance premiums to be paid. The bonus is taxable compensation to the owners and tax-deductible to the company.
• At the death of a partner, the life insurance proceeds are paid to the surviving owners to be used to acquire the deceased partner’s interest from their family or estate.
• The remaining partners receive a 100 percent stepped-up basis on the acquired interest, meaning they are only responsible for taxes on business gains from that point forward.
• Alternatively, to keep the number of insurance policies to a minimum, the partners could enter into a "trusteed" agreement administered by a professional trustee who purchases a single policy on each owner.

Stock-Redemption (Entity Plan) Agreement

• A stock redemption agreement, also known as an entity plan, is more appropriate for businesses with multiple owners organized as a C-corporation, S-corporation, or limited liability company (LLC). Here’s how a stock redemption agreement works:
• The business, or entity, formally agrees to acquire the shares of each owner at their death.
• The entity buys a life insurance policy on the lives of each owner, pays the premiums, and is named as beneficiary on each policy. Premiums paid by the entity are not tax deductible.
• At the death of an owner, the entity receives the life insurance proceeds and uses them to purchase their shares from their family or estate.
• Depending on how the business is structured, the remaining owners may or may not receive a stepped-up basis on the purchased shares. Owners of a C-corp do not receive an increase in basis. S-corp owners may receive a full cost basis increase under certain conditions. LLC owners receive a stepped-up basis in direct proportion to their ownership share.

For business owners in business with partners, their estate planning is not done until they incorporate a business continuation plan involving all owners. Crafting a buy-sell agreement can be a complex process, requiring the legal expertise of a business attorney. Using the right life insurance arrangement is also critical and should involve the expertise of an insurance broker specializing in business insurance. Finally, there are tax implications that should be considered with an experienced tax professional.