Life Insurance Funding for a Buy-Sell Agreement Insuring the Life of Your Business ISU Paragon One Responsible Source

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1 Life Insurance Funding for a Buy-Sell Agreement Insuring the Life of Your Business ISU Paragon One Responsible Source As a business owner, it is probable that your business has become one of your most valuable assets. What would happen to your business and family should you unexpectedly die? The general function of life insurance is to create a sum of money payable at the death of the insured in order to replace the economic loss resulting from the person's death. When used to fund your buy sell agreement, life insurance will create a sum of money at your death that will be used to buy your business interest from your family or estate. Have you thought about what will happen when you die? Does your CPA or Attorney have the Buy-Sell agreement spelled out in your business continuation documents? Do all partners or shareholders understand what will happen when you die and what the step are to keep the business running? Do your heirs have experience operating the business on a day-to-day basis to look out for their interests? Would your heirs be forced to sell their part of the business? Would your heirs receive a fair price? Does the company have the funds to pay for this in a lump sum? If the company could somehow make the financial arrangements to fund the Buy-Sell agreement, would they be handcuffed financially for years? What is the tax consequences of the sale on both your heirs and the company you helped build? Have you asked your CPA or tax attorney? These are difficult questions to answer. You owe it to yourself, your family and your company to protect these assets and years of hard work. Through proper planning, you can secure the continuation of your business and the financial security of your heirs. How The Buy-Sell Agreement Protects Your Business and Family? The death of a shareholder can cause a strain for the company resulting from the loss of talent, disruption of business, and the accompanying loss of revenue. A buy-sell agreement is a contract among business owners or partners. At the loss of an owner or partner, the business interest is transferred according to the terms of this contract. The other owner(s) or partners are obligated to purchase the deceased's business interest

2 and the deceased's heirs are obligated to sell at a predetermined price or valuation. Your Heirs Are free of business worries and guaranteed to receive a fair price for the sale of the business interest. May avoid some of the delays associated with probate. Surviving Owners Will not have to worry about new and possibly unwanted partners. Know the purchase price of the business beforehand. Remain in good standing with clients and creditors through a smooth transition of ownership. Simply put, a properly funded buy-sell agreement will benefit your family, surviving owners, and creditors. How to fund the Buy-Sell Agreement Option 1: Wait and Borrow Funds - In this option, surviving owner(s) borrow funds, usually bank loans, at the death of a co-owner to fund the buy-sell agreement. Future growth may be slowed due to an increase in expenses (repayment of loan). Death of an owner may cause sales to decline, compounding the problem. Death of an owner may make it difficult to receive a loan. A surviving owner may have to sign for funds, exposing personal assets. Surviving owners pay dollar for dollar plus interest for the deceased's outstanding share of the business. Bank credit was based on multiple owners. Now the bank is looking at just one guarantor and may not continue line of credit with current credit environment. Option 2: Use Life Insurance this option is the Smart Choice. Purchasing life insurance can be the most cost effective funding option for a buy-sell agreement as it provide the following benefits: Immediate availability of proceeds when death occurs. The funds used to buy the deceased's share are purchased for pennies on the dollar. Premiums are significantly lower than the cost of repaying the loan interest especially for amounts greater than $500,000. Death benefit proceeds are generally income tax free o The proceeds received from the policy generally do not constitute taxable income to the beneficiary of the policy when the beneficiary is an S corporation, the shareholders, or a third party. Caution: it s possible that a

3 C corporation may be subject to the alternative minimum tax (AMT) when it receives proceeds from a life insurance policy. Please check with your CPA or tax attorney. What Will A Buy-Sell Agreement Accomplish? Creates a market for the stock. Sets a predetermined price or valuation process at which owners agree to buy and sell their shares. The use of company funds to fund the plan. o In general, policy premiums are paid with after tax dollars and are not a deductible expense. This applies regardless of who pays the premiums the corporation, the shareholders, or a third party. Who owns the life insurance policy? Although certainly not an ironclad rule, the general arrangement is for the partners, partnership, stockholders, or corporation (whoever is the purchaser specified in the agreement) to pay the premiums. The party paying the premiums is also generally the owner of the policy and receives the proceeds of the policy at the death of the insured, whose interest in the business is to be purchased. How is the plan Funded for Company paid Entity Plans? The owners enter into an agreement with the business. The business applies for, owns, and pays the life insurance premiums on each owner. When an owner dies: The business will receive the life insurance proceeds. The business uses the proceeds to purchase the deceased's business interest. Heirs receive an agreed-upon price for their business interest. What happens if the insurance proceeds are less than value of interest? The insurance proceeds could be less than the value of your business interest due to growth of the business (or other reasons). Your buy sell agreement should specify what will happen when the value of the business is larger than the amount of the proceeds from the insurance company. Your buy sell agreement should specify how the proceeds/valuation difference will be handled. One possible option is for the buyer to make installment payments for the difference. Another is at the point of purchase elect a face amount higher than the agreed value and use the difference to fund the key man component of replacing a key member of the company. At the point of death these funds could be used to fund the disparity between the initial value verses the actual

4 value 5, 10 or 15 years later. We recommend relooking at the valuation of the company or partnership as part of the annual year end closing of the company's books and make adjustments as needed. The key to a proper Buy-Sell is it must be a win-win now and in the future for all parties concerned. To get started After the Buy Sell Agreement stating the purchase price, terms, and funding arrangements is drafted, an initial policy face amount must be established. A policy type will be elected, we recommend using no less than a 10 year term period if using term insurance. We also recommend only buying a term policy that offers a conversion option if available. This may help protect the organization if one of the owners/ partners becomes uninsurable. Using life insurance in a buy sell agreement requires all the procedures involved in buying personal life insurance. An application must be completed, including a completed medical history, and life insurance underwriting procedures must take place. The Business may be required to provide financial statements to verify value of the business. ISU Paragon has been selling and servicing life insurance policies for nearly 35 years. As a One Responsible Source insurance agency, we are uniquely qualified to help evaluate your needs to help eliminate burden of funding your company s continuation. We will also be here after the death of one of the partners or owners to help your family and company to make the process as painless as possible.

5 Updated 8/31/11

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