Articles

Insurance and Unintended Consequences: Does the Buy-Sell Do the Job?

Author: David P. Shapiro Date: 08/17/2023

Categories: Commercial and Construction Litigation, Commercial Leasing

 Image of a legal buy-sell agreement on a desk with a mobile phone, plant and notebooks.A buy-sell agreement outlines what happens to ownership interests in a business when one of its owners passes away and ensures the remaining owners have a clear plan in place to buy out the deceased owner’s share of the business.

While buy-sell agreements are invaluable tools for business owners, it is crucial to recognize the potential pitfalls that arise when they are not meticulously structured. Inadequate preparation can lead to a host of complications – disputes, financial burdens, unforeseen legal implications, and more. That’s why, when it comes to safeguarding your business interests, engaging the services of a skilled attorney is essential.

When business owners have a buy-sell agreement, an insurance policy may fund the buyout. But where does that money go?

It’s all in the documentation.

The insurance agents, attorneys and clients must create the documents necessary to

(i) ensure that the insurance policies properly fund the buyout agreements among the business’ owners, and

(ii) avoid having spouses and children become unintended business partners and co-owners in a business about which they have little working knowledge.

Business partners usually think if they buy insurance, the proceeds will automatically pay for the deceased owner’s shares. But that’s not always the case.

If the insurance policy is not owned by the right party, things can work out badly

Our law firm has seen nightmare scenarios that could have been prevented with some skilled legal planning.

For example, let’s say Able and Burt own a business and are both married. They each purchase $2M of insurance because their attorney told them they needed it. That way if one of them passed away, the other would have the proper funding for a buyout.

This sounds like a great idea, but here are some problems they might encounter if the buy-sell agreement is not communicated and set up properly:

  • Problem with the Agent. If no one explains to the insurance agent that the purpose of the $2M policy was to fund a buyout, the agent may make each of the partners the owner of their own policies, and makes their wives the beneficiaries. When Able dies,. Burt says that he was supposed to use the life insurance to buy-out Able’s ownership in the business. Able’s wife says that, since she was the beneficiary, it is her money and she is now Burt’s partner. Burt then has to use other after-tax assets to buyout Able’s interest.

This consequence could have been avoided by a conversation between the agent and the lawyer drafting the agreement and proper identification of the policy’s owner and beneficiaries.

  • Problem with the Ownership. The life insurance Agent makes the business the beneficiary, but Able is the owner of the policy. Able becomes sick and fears that his wife will not have adequate security. Because Able is the owner of the policy, he has the ability to change the beneficiary before he dies, and he changes the beneficiary to his wife. Same sad result: Burt again has to use other assets to buy out Able’s interest.

This consequence could have been avoided by a close examination of the policies upon delivery…and a contractual obligation between Able and Burt requiring the proceeds to be used to purchase Able’s interest.

  • Problem with the Buy-Sell Agreement. The insurance was purchased by the business and the beneficiary is the business. The Buy-Sell Agreement says that, upon a death, the business will be valued and then the company will buy out the decedent’s interest in the business for ½ of the valuation. The business was valued at $1M, so Burt is obligated to buy, and Able’s estate is obligated to sell, Able’s half of the business for $500,000. The business received $2M and kept $1.5M, notwithstanding that Able paid the premiums and was taxed for all the premium payments.

This consequence could have been avoided by an upfront conversation between attorney and client to determine who would benefit from any insurance proceeds in excess of the purchase price.

Buy-Sell Agreements and the underlying insurance policies that are used to control business relationships must be reviewed regularly.If not, there could be unintended consequences in the unfortunate event of a buy-out upon one owner’s death. Business owners and their legal counsel should always be vigilant, ensuring that the documents remain relevant and effective.

Ensure a solid foundation for your business succession plan by consulting our experienced attorneys. Our team understands the complexities of buy-sell agreements and can guide you through the process with precision and expertise. Contact us now.