Buy/Sell Basics

Learn what plans your clients can put in place, and which plan to choose.

By Glenn Stevick, CLU, ChFC, LUTCF

When a business needs a buy/sell agreement, it will have to decide between two types: the cross-purchase plan and the stock redemption plan (or entity plan). The main difference between the two is who will be the buyer of the deceased owner’s business interest. Here’s a look at the two choices and when each is appropriate.

The cross-purchase plan:
This is an agreement between individual owners in which the surviving owners buy the ownership interest of the deceased owner at a price stipulated in the contract, either a specified dollar amount or one determined by formula. When funded with life insurance, each owner is the applicant, premium payer, beneficiary and owner of policies on the lives of the other owners in an amount equal to each owner’s share of the purchase price.

Assume there is a three-owner company valued at $1.5 million, with equal ownership valued at $500,000 each. Under a cross-purchase plan:

• Owner A owns $250,000 of life insurance on B and C
• Owner B owns $250,000 on A and C
• Owner C owns $250,000 on A and B

Assume owner A dies. Owners B and C will each receive $250,000 in life insurance proceeds, which they pay to A’s estate in exchange for A’s interest. B and C become equal $750,000 owners. They may have the option to purchase the policies on their own lives from A’s estate by paying an amount that is essentially equal to the cash value. They should buy an additional $500,000 on each other to fund the continuing agreement.

The number of policies each owner must buy is equal to the number of owners minus one, since each owner does not buy a policy on himself. Thus the total number of policies needed would be the number of owners times the number of owners minus one N(N-1). With four owners, the number of policies needed would be 12: 4(4-1)= 12.

The corporate stock redemption plan or entity plan: This is an agreement between the corporation and its stockholders. The deceased stockholder’s estate sells the deceased owner’s interest to the corporation, and the corporation buys the stock of the deceased stockholder. When funded with insurance, the corporation is applicant, premium payer, beneficiary and owner of insurance on the life of each owner equal to the value of each owner’s interest.

Assume a five-owner corporation valued at $1 million, with each owner owning a $200,000 interest. The company buys $200,000 of life insurance on each owner. Upon the death of one of the owners, the company receives $200,000 cash from the life insurance company and pays the deceased owner’s estate for the deceased’s interest in the corporation.

The interest of each of the four surviving owners increases from $200,000 to $250,000. The company then insures each surviving owner for an additional $50,000 to fully cover the revised insured buy/sell agreement.

In noncorporate forms of business, the plan is called an entity plan because there is no stock.

The choice
The entity plan is sometimes selected because shareholders are more willing to use corporate funds than personal funds. In the case of a large number of owners, the number of policies involved favors the entity plan. Under a cross-purchase plan with eight owners, 56 policies would be required; an entity plan would need only eight.

Before an entity plan is adopted, the corporation must have the legal power to buy its own stock. Such purchases can be made if the purchase price is determined in good faith, will not endanger corporate solvency or be harmful to creditors and owners. The cost basis of the shares on subsequent sale is another important issue and generally favors a cross-purchase arrangement.

Under the cross-purchase plan, a problem may develop if there is a substantial difference in ages. If one owner were 20 years younger than another, the younger owner would pay a much higher premium that he may find difficult to pay. The older owner might help by sharing some of the premium. An extra amount of insurance could be purchased on the older owner so that if the older owner dies first, his estate could be reimbursed for the extra premiums paid.

Under the entity plan, each owner indirectly pays a share of the total premiums of all policies. If the premiums are $3,000 and there are three equal owners, each in effect pays $1,000 when the corporation writes the check. Questions may emerge about the fairness of payments made in proportion to the percentage of ownership. The older owners may disregard this inequity in view of the probability that the younger owners would outlive them. The advantages to their own families may outweigh the extra costs.

Glenn Stevick, CLU, ChFC, LUTCF, is an LUTC author and editor with The American College and a member of Tri-County AIFA (Pa.). He can be reached at Glenn.Stevick@TheAmericanCollege.edu.