Contractors commonly use life insurance as a funding mechanism for buy-sell planning and insuring key employees. Because death is a common trigger in a buy-sell agreement, life insurance, when used as the funding mechanism for the agreement, provides the immediate liquidity to fund the buyout when the need arises. It’s an elegant solution, but complications do arise. When they do, it’s usually a question of whether the insurance is being managed, monitored and serviced as it ought to be.

Life insurance as an industry isn’t usually associated with client service—and herein lies the problem. A lack of consistent monitoring by policyholders can result in disastrous tax ramifications. For instance, in calculating gain on a policy, the cash surrender value is added to any outstanding loans on the policy less cost basis. If a policy lapses, no cash value is paid out. But if there is a $100,000 loan on the policy and the cost basis is $50,000, then the policyholder (the company) may be liable for paying income taxes on $50,000, even though nothing was received.

The tax implications are complicated, and they can be severe enough to diminish the goals established when the policy was created. For this reason, business owners should regularly review their buy-sell agreements and their insurance policies individually as well as in relation to each other.

Options other than life insurance exist for funding a buy-sell agreement. For example, owners can complete a buyout with a loan or create a sinking fund (or savings, so to speak). But life insurance provides an easy method. After all, it’s a simple mechanism for paying out cash at the time it’s needed. Plus, funding a buy-sell agreement from business capital can cripple that business later on. Even if the company has significant value, it’s not always liquid, so it would be rare for a business to actually manage that buyout.

Common Issues With Buy-Sell Agreements
One of the problems owners often face is incomplete buy-sell agreements. Business owners frequently begin the process of creating a buy-sell agreement only to leave it sitting in draft form, never signed. The result is a nonbinding agreement. If a company has an incomplete buy-sell agreement, it’s important to complete the process as soon as possible.

Another common problem is agreements that talk about what will happen at death or disability, but miss other critical elements. Is the agreement actually funded? Is there a plan and mechanism to carry out its goals? Often clients have an agreement, but never create a plan to follow through. For example, an agreement may call for a buyout at death, but if no insurance, funding pool or loan arrangement is ever established, funding the agreement could be problematic if an owner dies.

Another concern is whether the insurance ownership structure matches the agreement. The obligation to carry out the agreement lies in the wording of the actual buy-sell agreement, so the funding mechanism (in this case, the insurance) must match the agreement. If the agreement says that the individual owners will buy out the deceased owner, but the insurance is owned by the company, then the individuals who are required to buy out the estate have no money or method for doing so—and negative tax consequences may be the result.

In this situation, the question becomes: How does the surviving owner get the cash? Does the company distribute the proceeds to the surviving owner? If so, is this income taxable? Is it a distribution, and does it reduce basis in the policy? What does it mean to the deceased owner’s estate? Does the estate receive a distribution as well? The questions that result can become complex, and unplanned tax exposure that follows can take vital dollars away from the buyout plan. 

Life Insurance That Meets a Company’s Needs
Of course, having the right insurance upfront is also critical. Is the insurance product suitable for the goals of the arrangement? For example, if the owners plan to sell the business within a 10-year period, then a term policy is probably the most appropriate product. If the owners buy a permanent product instead, they’re probably paying more money for something they don’t need. Furthermore, a permanent product may result in tax consequences, because if the business does sell, the owners will be left with policies they don’t know what to do with.

It’s always important to annually review policies, particularly if the existing insurance relies on the market. Because market performance can affect policy performance, downturns can result in policies expiring sooner than expected, requiring more in premiums, or even inadvertently generate loans.

In addition, insurance companies can undergo changes and can lose their financial stability, or the original policy may have been placed with a low-grade company in order to save on premiums. It may no longer make sense to sacrifice financial stability to save a few dollars. 

Finally, circumstances and values change. When an event changes the nature or outcome of a business, it’s important to review the firm’s insurance alongside its buy-sell agreement so that both can accommodate the changes and continue to work together.

Insurance Needs TLC
Insurance is often a forgotten investment. Companies think if they pay their premiums, they’re good to go, but policies require regular and careful review. Term periods often expire or, without realizing it, companies continue to pay extravagant increases in premiums due to poor performance.

Neglect makes it easy for insurance to become misaligned with the buy-sell agreement—either in product, amount or need—and the result is a policy that no longer accomplishes what the company created it to do. The best approach is to integrate it with other major aspects of the business plan. 


Aimee Kwain is senior insurance specialist for Moss Adams Wealth Advisors LLC. For more information, call (310) 295-3727 or email aimee.kwain@mossadams.com.