Life (Insurance) and Death and Agency Perpetuation

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1 Life (Insurance) and Death and Agency Perpetuation Every insurance agency needs to have a written perpetuation plan. If there is more than one owner of the agency, it is absolutely critical that you have a valid, enforceable buy-sell agreement. In corporations this is known as a Shareholders Agreement, limited liability companies have a Members Agreements, and partnerships have a Partners Agreement. Regardless what you call it, at a minimum the agreement should address death, disability, retirement, involuntary termination of a shareholder, and involuntary conversion in situations such as divorce or bankruptcy. From purely a funding perspective, death seems to be the easiest of these events to deal with. Just buy a life insurance policy and funding is taken care of. However, structuring the insurance incorrectly can cost the surviving shareholders significant money. Classifications of Stock What percentage of the agency do you own? It seems like a simply question but surprisingly, many people answer incorrectly because they don t understand how stock can have different classifications: Authorized: When a business incorporates, the Articles of Incorporation state the number of shares authorized. This is the maximum number of share that the business can issue without amending the Articles of Incorporation. Issued: The corporation issues stock to shareholders. While the number of shares issued can equal the number of shares authorized, it is usually a good idea to leave some shares authorized but unissued in case the corporation wants to issue additional shares in the future. Treasury Stock: These are the issued shares that the corporation has bought back from shareholders. They can be reissued in the future, just like authorized but unissued shares. Outstanding Stock: Outstanding stock equals the issued stock minus any treasury stock. A shareholder s percentage ownership is equal to the number of shares the shareholder owns divided by the total outstanding stock. Example: Bob, Joe and Fred start an agency from scratch, and the articles of incorporation authorize 10,000 shares. The corporation issues 500 shares to each of the three partners (1,500 total shares issued) each of whom owns one third of the agency. A few years later Fred retires and the corporation buys back Fred s shares.

2 The status of the stock at this point is: Authorized: 10,000 Issued & outstanding 1,000 Treasury Stock 500 Bob and Joe still each own 500 shares but now they each own 50% of the corporation since treasury stock is not factored into percentage ownership. Life Insurance Ownership Depending on how you have structured your Shareholders Agreement and Life Insurance, you either have a stock redemption agreement or a cross-purchase agreement. Stock Redemption In a stock redemption agreement the corporation owns the policies, is the beneficiary of the proceeds, and uses those proceeds to buy back the stock of the deceased from the estate of the deceased. This stock then becomes treasury stock. Assume the corporation is worth $2 million and the corporation has a $1 million life insurance policy on Bob and a $1 million policy on Joe. Joe dies. The $1 million life insurance proceeds go to the agency which then pays the $1 million to Joe s estate. Joe s 500 shares now become treasury stock. Although Bob still owns 500 shares, he now owns 100% of the agency since treasury stock is not outstanding. A few years go by and Bob sells the agency for $3 million. The entire $3 million is taxable. Cross Purchase In a cross purchase situation, the shareholders (not the corporation) own the policies on each other. When a shareholder dies, the proceeds go to the beneficiary, i.e. the survivor. The survivor uses the proceeds to buy back the stock of the deceased. Again assume the corporation is worth $2 million but now Bob and Joe each have a $1 million life insurance policy on each other. Joe dies. The $1 million life insurance proceeds go to Bob who pays the $1 million to Joe s estate. Bob now owns 1,000 shares of stock and 100% of the agency. In both of the above situations Bob ends up owning 100% of the agency. So what s the big deal?

3 A few years go by and Bob sells the agency for $3 million. Only $2 million of the $3 million is taxable. Since Bob paid $1 million for the stock the IRS deems that he has $1 million in basis. (Basis is what someone pays for an asset less any depreciation expense, or amortization in the case of an intangible asset, that has been claimed on his/her tax return), By structuring the deal as a cross purchase rather than a stock redemption, the surviving shareholder enjoys significant tax savings. In the stock redemption situation, Bob has no basis since he didn t pay for Joe s stock. Number of Policies If there are only two shareholders you only need two policies. But what if you have more than two shareholders? If you have three shareholders you need six policies. Four shareholders need 12 policies. The formula to determine number of policies needed is: Number of policies needed = X times (X 1) where X equals the number of shareholders. If you have six shareholders you need 30 policies, or do you? Once you go beyond three shareholders you should consider setting up a separate trust that does nothing but hold the policies and distribute the proceeds on behalf of the members of the trust, (which are the shareholders). That way if you have 12 shareholders you only need 12 policies. Not only do you need fewer policies, it s easier to manage. Existing Policies What do you do if you currently have a stock redemption situation and existing policies? If the policies are term policies, the answer is simple. Change your agreement to a cross purchase agreement and change the owners and beneficiaries of the policies. If the existing policies are not term policies and they have significant cash surrender value, you have a problem. If the policies are transferred from the corporation to the individual shareholders, the cash surrender value becomes taxable income to the new policy owner. If want to switch to a cross purchase arrangement in this situation it is usually best to get new term policies issued, assuming everyone is insurable at a reasonable cost. How Much Insurance? Most insurance agents say you should purchase as much life insurance as you can comfortably afford. But how much is enough?

4 Go back to your Shareholders Agreement. Does it address the value of the agency? If it states a formula, you know the value of the agency. If the Shareholders Agreement doesn t state the value of the agency, you should get the agency valued by a qualified professional to determine the fair market value of the agency. In either case, the value of the agency will fluctuate over time. Therefore, buy more than enough insurance to cover the current value as well as any reasonably expected increase in agency value. Who Pays the Premium? Ideally, the shareholders should pay the premiums personally. The funds can come from them personally or the agency may issue a bonus / dividends / etc. to give the shareholders the funds to pay the premium. Another option is to have the agency pay the premium in a cross purchase situation. In either event, the policy premium needs to be included on the beneficiary s W-2 and documented properly. Whether it s a cross purchase or stock redemption agreement, under no circumstances should the premium payments be taken as a tax deduction. Doing so will result in the proceeds being taxable to the beneficiary. Too Much or Not Enough? If a shareholder dies and the life insurance proceeds on the deceased exceed the purchase price of his/her shares of stock, the excess is retained by the beneficiary of the policy unless the Shareholders Agreement states otherwise. But what if the value of the deceased s ownership in the agency exceeds the proceeds of the life insurance policy? Unless the Shareholders Agreement states otherwise, the surviving shareholder will have to find a way to come up with the shortfall. If he/she is unable to do that, it could force him/her to sell the agency. A well structured Shareholders Agreement will address shortfall situations and provide the surviving shareholder with the option to pay off the balance due the deceased s estate over some period of time at a reasonable interest rate. Conclusion Properly crafted Buy-Sell Agreements are critical for the agency to survive the death of a shareholder. Failing to properly structure such agreements can result in lawsuits, additional taxes, and the potential death of the agency itself. If you don t have an agreement or if you haven t reviewed it recently, it is wise to engage a professional to assist you in this life and death situation. About the Author Jon Persky, CIC, CPA, PHR

5 Jon is the president of Optimum Performance Solutions, LLC ( an insurance agency consulting firm providing valuation, merger and acquisition, agency perpetuation, strategic planning, and marketing and retention services to insurance agencies nationwide. Jon is on the national faculty of the Society of Certified Insurance Counselors and lectures on agency management topics throughout the United States. He can be contacted at or Reproduced from the Winter 2011 issue of Resources magazine with permission of The National Alliance for Insurance Education & Research.