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A recent Supreme Court decision has changed how we think about buy-sell agreements and life insurance. The court ruled that life insurance proceeds used in business buyouts need to be counted differently for tax purposes. And if you're a business owner or financial advisor, you'll want to know more about this.

In this guide, we're going to walk through the different types of agreements you can use, show you how life insurance fits into the picture, and give you practical ways to value your business interests. Let’s dive in. 

Understanding Buy-Sell Agreements

Buy-sell agreements shape how ownership changes hands when major events occur. They're a bit like prenups for businesses, setting clear expectations and protecting everyone involved. And just like you'd protect your family with life insurance, these agreements work with insurance to safeguard your business's future.

They're legal tools that help you manage ownership changes in your business, and they're a bit more flexible than you might think. When someone needs to leave the business — whether it's planned or unexpected — these agreements make sure everyone knows exactly what'll happen next.

Types of Buy-Sell Agreements

You've got two main options here, and each one works a little differently:

Entity-Purchase Agreement

This is when your business buys out the departing owner's shares. It's great for corporations and LLCs because it keeps things simple — the company handles the purchase directly. And with 45.82% of direct premiums concentrated among the top insurance providers, you've got some solid options for funding these agreements.

Cross-Purchase Agreement

In this setup, the remaining owners buy the shares themselves. It works really well for partnerships, and you don't have to worry about corporate tax implications. The owners can keep their relative stakes in the business just the way they want them.

Why These Agreements Matter

They're important for a few key reasons:

• First, they help prevent those difficult situations where owners disagree about what should happen next. That's especially valuable when you're dealing with unexpected events — and we all know how tough those can be.

• Second, they give you financial breathing room. When you need to buy out someone's share, you don't want to be scrambling for funds. A good agreement makes sure you're ready for that.

For family businesses, these agreements are particularly valuable. They help keep the business in the family while making sure everyone's treated fairly. Speaking of which, if you're running a family business, you probably know how tricky these conversations can be.

Role of Life Insurance in Buy-Sell Agreements

Life insurance is a key player in making buy-sell agreements work. With the market expected to reach $16.7T by 2033, it's becoming an even more important tool for business planning. In 2023 alone, insurance companies paid out $831.9B in benefits, showing just how much businesses and families rely on these policies.

How Life Insurance Makes It Work?

When you're setting up a buy-sell agreement, life insurance does the heavy lifting in a few ways:

First, it gives you cash right when you need it. If an owner passes away, the policy pays out quickly, so you can handle the buyout without putting stress on the business's finances.

Then there's the value piece — you can match your policy amount to what the business is worth, which makes everything crystal clear when it's time to use it.

Why Does Life Insurance Make Sense?

The benefits are pretty straightforward:

1. It's cheaper than you might think, especially compared to setting aside a large sum of cash

2. Getting the money is simple and fast

3. The tax situation works in your favor, since death benefits usually come tax-free

Triggering Events in Buy-Sell Agreements

Different things can trigger your buy-sell agreement:

• Death. If an owner passes away (that's the most common one), the agreement springs into action. The life insurance gives surviving owners or the business the funds to buy the deceased owner's share, and their family gets fair value for their portion of the business.

• Disability. Sometimes owners can't work anymore, and the agreement helps everyone handle that transition smoothly.

• Retirement. That’s probably the happiest reason to use these agreements. You can plan ahead for this one, making sure everyone's ready for the change.

Valuation Methodologies for Business Interests in Buy-Sell Agreements

Let's talk about figuring out what a business is really worth. With combined ratios improving to 98.5% in 2024-2025, we're seeing more stable valuations, but you'll still want to get this part right.

Different Ways to Value Your Business

You've got a few options when it comes to putting a number on your business. Each one has its own strengths, and you might want different approaches for different situations.

Professional Appraisals

Getting a professional appraiser is like having someone take a really good look at your business through different lenses. They'll check out your assets, think about how much money you could make in the future, and see what's happening in the market right now. It's thorough, and that can be really valuable when you need to be certain about the numbers.

Formula-Based Approaches

Some businesses like to keep things simple with preset formulas. You might base it on how much revenue you bring in, or use Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) multipliers. It's straightforward, and everyone knows what to expect.

Choosing What Works for You

Each method has its positives and negatives. Professional appraisals might cost more and take longer, but they're thorough. Formula approaches are faster and easier, but they might miss some of the finer points about what your business is worth right now.

Paying for Buy-Sell Agreements: Your Options

When it comes to funding these agreements, you've basically got two main paths: cross-purchase and redemption agreements. Both can work well — it's just about finding what fits your situation better.

Cross-Purchase Setup

This is where each owner buys insurance on the other owners. It's more personal, and you get to control your own policies. The money goes straight to where it needs to go, which can help with taxes. But if you've got several owners, you might end up juggling quite a few policies.

Redemption Approach

Here, your business owns all the policies. It's simpler to manage since everything's in one place. The company handles buying back shares when needed. You might need to think about some tax implications, though, and it's not quite as flexible for individual needs.

Tax Implications Related to Life Insurance in Buy-Sell Agreements

Let's talk about everyone's favorite topic — taxes and tax planning. When you're dealing with life insurance and buy-sell agreements, there are some important tax angles to consider. 

Income Tax Basics

Here's something that might make you feel better about your planning: when someone receives life insurance money, they usually don't have to pay income tax on it. That's a big deal. But there's a catch — if the money goes to the person's estate instead of directly to beneficiaries, it might get wrapped up in estate taxes.

Estate Tax Planning

You'll want to pay attention to something called “Section 101(j)” of the Internal Revenue Code. It's actually pretty helpful because it lets you keep insurance money out of the taxable estate — if you set things up correctly. The key is getting the ownership and beneficiary parts right from the start.

Making It All Work Together

Setting up these agreements takes some careful planning, but it's worth doing right. You might want to work with someone who really knows their way around these agreements — they can help you avoid those "gotcha" moments with the IRS down the road.

Challenges in Implementing Buy-Sell Agreements

Setting up buy-sell agreements might sound straightforward, but you'll probably run into some bumps along the way. Let's talk about what could go wrong and how to handle it.

Dealing with Corporate Creditors

One of the trickiest parts is handling creditors. When someone leaves the business — whether planned or not — creditors might try to stake their claim on the departing owner's share. It can get messy, and you'll want to be ready for it.

Keeping Your Policies on Track

Then there's the whole process of managing life insurance policies. Missing a payment or getting the structure wrong could really throw a wrench in your plans. It happens more often than you'd think, especially when businesses are juggling multiple policies.

When People Disagree About Value

You might find that different owners have different ideas about what the business is worth. These disagreements can get pretty heated, and that's tough — especially when you're trying to keep business relationships intact (or even family relationships, when it’s the case of family businesses).

Final Thoughts

Buy-sell agreements and life insurance work together to protect what you've built. Getting all the pieces right — from valuation methods to tax planning — takes some careful thought. And with recent legal changes, it's more important than ever to structure these agreements correctly.

You don't have to figure it all out on your own, though. Financial advisors who specialize in business planning can help you understand your options and create an approach that works for your specific situation. They can walk you through different scenarios, explain the tax implications, and help you avoid common pitfalls.

Modern technology has made it easier to connect with advisors who understand the complexities of buy-sell agreements and business succession planning. Using platforms like FINNY, you can find professionals who might guide you through this process, taking into account your business structure and goals.

Get matched with a financial advisor.