When circumstances require the owners of a business to execute a previously arranged buy-sell agreement, sufficient cash may not be available to the entity, or to its owners, to make it feasible for the purchase of a withdrawing owner's interest. Usually, if the owners and/or the entity, as the case may be, are unwilling or unable to make the purchase, the buy-sell agreement provides that the withdrawing owner is free to sell his interest to an outsider.
Clearly, this defeats the very purpose of the buy-sell agreement. For this reason, life insurance, on the withdrawing owner's life, is frequently used to the finance the purchase of the interest.
When something called a cross-purchase agreement is used, owners take out life insurance polices on each other's lives. With the use of an entity-purchase agreement, the entity takes out polices on the lives of its owners, with the entity named as the beneficiary of the policies. The cross-purchase agreement is more commonly used in practice.
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Obviously, life insurance can only be used to fund a purchase made on account of an owner's death. Funding the purchase of a withdrawing owner's interest, in other cases, can be controlled in several other ways.
The operating agreement may provide that an owner may not withdraw, except upon unanimous consent or subject to other enumerated conditions.
For example, the operating agreement might allow withdrawal by an owner who suffers a permanent disability. "Permanent disability" could be defined as a disability that prevents the owner from working in the business for six consecutive months. Disability insurance might be used, in the same way life insurance is used, to facilitate the purchase of the interest.
In addition, the buy-sell agreement may provide that, in certain cases (e.g., a voluntary withdrawal) the interest is to be valued at a lower amount (e.g., book value). Moreover, the buy-sell agreement may provide that the interest is to be purchased in installments, over a fixed period (e.g., five or 10 years). Any of these options can make it more practical to purchase the interest.
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