Alternative Funding Options for a Buy-Sell Agreement without Insurance

Options for Those Without Insurance

Occasionally, life insurance is the preferred method of funding for a buy-sell agreement, but one or more parties are uninsurable. There are alternative funding options available for this situation. Several of these are discussed in Fund Your Buy-Sell Agreement with Instruments Other Than Insurance, and they include:

Cash Savings Account

When there is an uninsurable shareholder, the sinking fund can be used to attempt to collect at least a down payment on the business interest. Typically, the company deposits an amount equal to the appropriate insurance premium for the individual's age into a separate account that may be invested in a mutual fund or an annuity. If the sinking fund is insufficient to pay for an owner's interest at the time of the buy-sell transaction, the remainder can be paid in installments.

A cash-sinking fund is exposed to the company's creditors, which disadvantages its use. The court could order the company to use the funds to pay its creditors.

Installment Payments

Acquiring a non-insurable shareholder's business interest may be financed with installment payments. A payment plan could be established as part of the buy-sell agreement's funding clause. Installment payments generally require a down payment (the larger, the better) and periodic payments of the remaining balance plus interest. If the down payment is sufficient, your estate may be able to cover estate and death taxes.

Deferred Payroll Benefits

A non-insurable shareholder can receive deferred compensation to fund the buy-sell agreement. This alternative requires planning in advance, so the sooner it is implemented, the better. Deferred compensation can provide buy-sell agreement funding payments that are at least partially, if not wholly, tax deductible for the business. By establishing deferred compensation funding for the buy-sell agreement, you accept the promise of future payment for a salary the company can likely not pay you today. The payment of income taxes on the additional salary is deferred until the money is received. In addition, the portion of the purchase price of your stock that represents deferred compensation is tax-deductible for the company when the payment is made.

When the buyer of your interest is the business or other shareholders, deferred compensation funding may be utilized; in both instances, tax-deductible deferred compensation payments cover a portion of your interest's sale price. When co-owners purchase your business interest, the deferred compensation amount is subtracted from the amount paid by the individuals.

Coverage Extension for Insurable Parties

The purchase of additional insurance coverage on insurable shareholders to compensate for the uninsurable shareholder's lack of coverage is a funding option sometimes considered when acquiring the interest of an uninsurable shareholder. One option is to purchase twice the coverage that would ordinarily be purchased on the insurable shareholders' lives. If the insured shareholder dies before the uninsurable shareholder, a portion of the insurance proceeds could be used to purchase the insured shareholder's interest, with the remainder reserved for the future purchase of the uninsurable shareholder's interest. This would not be advantageous if the uninsured shareholder died first.

It may be challenging to qualify for and purchase coverage twice the required amount.

Use of Insurance with Greater Cash Values

Another option is to use the funds that would have been spent on insurance for the uninsurable person to purchase building policies with a higher cash value for the insurable shareholders. If the uninsurable shareholder dies before the insured shareholders, the insured shareholders can use the excess cash values to purchase the uninsurable shareholder's interest.

Caution: Purchasing larger cash values entails purchasing larger face amounts, which results in higher premiums.

Utilization of Existing Insurance

An uninsurable shareholder may have previously purchased personal insurance coverage when he or she was insurable. When the existing personal coverage exceeds what may be needed due to changes in life circumstances, it is sometimes considered an option under the buy-sell agreement to transfer the existing coverage to a potential buyer to fund the purchase.

Caution: While this may appear a good option, it ultimately protects business partners at the expense of the insured shareholder's family.

This option may result in a transfer-for-value, subjecting the death proceeds to income taxation. Without this transfer, the proceeds would have been received tax-free.

Low-Quality or High-Risk Insurance

Numerous insurance companies now offer policies to individuals deemed substandard or high-risk. The insurance company charges a higher premium to compensate for the additional risk posed by the individual's advanced age or poor health. The premiums for this type of insurance could make one of the other options more attractive.

Loans/Real Estate Mortgage

A non-insurable shareholder's business interest may be purchased with borrowings or mortgage proceeds. This option may be accompanied by significant uncertainty. There is a chance the buyer will be unable to obtain a loan or mortgage when needed, or the economic climate may make borrowing difficult or prohibitively expensive.

Section 303 Stock Purchase

A Section 303 stock redemption is the purchase of a closely held corporation's own stock upon the death of a shareholder, which, if certain conditions are met, is eligible for favorable tax treatment under Section 303 of the Internal Revenue Code. Congress enacted Section 303 to alleviate the liquidity problem of estates comprised primarily of closely held business interests. The business entity may acquire your ownership stake by the terms of a buy-sell agreement governing entity purchases (stock redemptions). Under Section 303, you are not required to have a formal agreement to sell your corporation's stock, but it is highly recommended, especially if you are not the majority shareholder.

Appreciated Real Estate Rescue

The fair market value of an appreciated asset is more significant than its adjusted basis in the hands of the distributing corporation. In other words, if sold outright, the property's value exceeds the value listed on the company's books. This can occur if the business has held the property for an extended period of time. Suppose your buy-sell agreement is between you and the corporation (an entity purchase (stock redemption) buy-sell agreement). In that case, the corporation may give you appreciated stock in another company, real estate, or other appreciated property in exchange for your corporation's stock. This is a bailout for appreciated property. A corporation and its shareholder who participates in an exchange of appreciated property may incur taxable gains.

The Lynch Retirement Investment Group has prepared some of the following materials. The material is considered reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. The investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James Financial Services, Inc. does not provide advice on tax, legal, or mortgage issues. These matters should be discussed with the appropriate professional.

These policies have exclusions and limitations. The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased.  As with most financial decisions, expenses are associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Guarantees are based on the claims-paying ability of the insurance company.

Lynch Retirement Investment Group 2016, 2017, 2018, and 2019

John M. Lynch, CIMA®, CPWA®

John M. Lynch, CIMA®, CPWA® Managing Director – LRIG
Financial Advisor– RJFS, of The Lynch Retirement Investment Group, LLC.
Was named on the 2021 Forbes Best-In-State Wealth Advisor List.

John M. Lynch, CIMA®, CPWA® Managing Director – LRIG, Financial Advisor – RJFS

Andrew Fentress, CFP® Financial Advisor

Adam Tobin, CFP®, CRPC Customer Relationship Manager

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