Life insurance professionals can help drive family business succession planning action. However, determining if life insurance makes economic and planning sense takes multiple perspectives. Each advisor in a team may provide insight into the insurance decision-making process that’s both essential regarding the value of life insurance in the family’s plan, but also helpful in educating the business owner and their family. Here are some interesting uses of life insurance for family business advisory teams to consider.

Entity Redemption Agreement

This is a legal agreement obligating the business entity to purchase all or part of an individual owner’s interest in the business for an agreed-on price. The primary reason a family business would consider implementing such an agreement with life insurance is to help create liquid dollars to pay estate taxes. Liquidity is vitally important in family business succession planning, and finding it often isn’t easy.

Traditionally, under Internal Revenue Code Section 2042, the proceeds (death benefits) of a life insurance policy owned by an individual are included in that individual’s estate, regardless of who the beneficiary is. However, life insurance owned by a business on an individual owner or key person generally isn’t includible in the insured’s estate. In addition, life insurance benefits payable to the business are typically received free of income tax.

The proceeds of life insurance owned by a business are, however, typically includible as an operating asset in the valuation of the business. Therefore, using life insurance as a financial tool inside the family business for succession success has often gone unexplored, given the valuation challenges (that is, the concern that the death proceeds will add to the value of the family enterprise, thus negating the benefits of the life insurance liquidity). Instead of focusing on the family business as a potential owner of life insurance, many business owners have used traditional irrevocable life insurance trusts (ILITs) in concert with a gifting strategy to fund liquidity needs at death. 

Combining With Buy-Sell Agreement 

Using life insurance in concert with a buy-sell agreement isn’t a new idea. Employing an entity redemption agreement alongside a buy-sell agreement simply expands this type of planning.

How it works. The agreement itself creates a legal requirement that the business must purchase part, or all, of the stock at the time of the business owner’s death. The amount of business interest to be redeemed is often equal to the estate tax projected.  

The family business applies for and owns a life insurance policy on the business owner’s life. The business pays the policy premiums and is the policy’s beneficiary—the premiums aren’t deductible. When the business owner dies, the business receives the life insurance proceeds, in most cases, income tax-free. Then, pursuant to the entity redemption agreement requirement, the business purchases, using the cash from the insurance policy proceeds, the agreed-on business interest from the owner’s estate. The estate’s executor then has cash that may be used to meet estate tax obligations and other settlement costs, and the business may redistribute shares to the remaining owners or hold them.