If there is life insurance associated with your buy-sell agreement, it is critical to be sure that the language in the agreement and any related documents specifies its treatment precisely. It is safe to consult a UtilitySavingExpert. Life insurance can be used as a funding vehicle to acquire the stock of a deceased owner.  If so, the life insurance is not treated as part of the purchase price.  Alternatively, life insurance can be a corporate asset (corporate-owned life insurance, or COLI), and proceeds are part of value.

The two different treatments provide different, perhaps dramatically different results for selling owners and remaining owners when buy-sell agreements are triggered by the death of an owner.

The following discussion provides an overview of the differences in treatment of life insurance on the financial condition of the company and of the shareholders, both deceased and remaining, as well as their ownership positions.  We will show two hypothetical examples:

1. Harry and Charles own a company, with each owning 50% of the stock.  There is adequate life insurance in place, and Harry dies.
2. Harry, Charles and William own a company, with each owning 40%, 30%, and 30%, respectively.  William dies.

We look at each of these hypotheticals under two assumptions regarding life insurance treatment:

• The life insurance proceeds are intended to be a funding vehicle to repurchase the shares of a deceased owner.  In this case, life insurance proceeds are not included in value to determine the price for buy-sell agreement transactions.
• The life insurance is intended to be a corporate asset the proceeds are included in value to determine the price for buy-sell agreement transactions.

The distinction between the two hypotheticals creates a difference in equity value equivalent to the life insurance proceeds received by a company upon the death of a shareholder.  It is that difference that makes it vitally important for business owners to pay careful attention to the link between buy-sell agreements and the use of life insurance proceeds upon the death of an insured shareholder.

Two Equal Owners: Example 1 (a and b)

Harry and Charles own the company equally.  The company is worth $10 million, which has been established by the single appraiser agreed to in the buy-sell agreement.  The agreement is assumed, for Example 1a, to call for the life insurance proceeds to be used as a funding vehicle, so the proceeds are not included in value for purposes of the buy-sell agreement.

We see on Lines 2 and 3 above that Harry and Charles own 50% of the company each and their ownership interests are valued at $5 million each based on the Appraisal, which does not consider life insurance in the valuation.  The company has life insurance policies of $6 million each on the lives of Harry and Charles.  Unfortunately, Harry died.  Shortly thereafter, life insurance proceeds of $6 million were received by the company.

The proceeds are considered for the company (Line 6) and Harry’s estate is paid the $5 million it is owed per the buy-sell agreement (Lines 9 and 10), and Harry’s shares are retired.

Charles now owns 100% of the 50 shares remaining outstanding, and the company is worth $11 million, since there was $1 million of over-insurance on Harry’s life.  As result of the operation of the buy-sell agreement, Charles’ interest increased more than $6 million in value (i.e., more than 100%,) as result of the operation of the buy-sell agreement.

Harry’s estate received $5 million, which was 50% of the pre-death value of the company.  One can argue that this arrangement is not fair to Harry’s estate, because of the disproportionate shift in value towards Charles.  However, the result would have been the same but in Harry’s favor had Charles been the first to die.

Now we look at Example 1b in which the appraiser is instructed to consider the life insurance as a corporate asset and therefore the proceeds are included in value for purposes of the buy-sell agreement.

At Line 7, we see that the appraised value, including the life insurance proceeds, is $16 million, and Harry’s estate value is $8 million (as is Charles’ value).  This means that the repurchase liability is $8 million, or $2 million greater than the life insurance proceeds of $6 million.

The shares are redeemed (Lines 10 and 11), with the company borrowing $2 million to accomplish the purchase.  The company’s equity value is reduced by the extent of the payment in excess of the life insurance proceeds.

Harry’s estate received $8 million, or $3 million more than the value prior to the consideration of life insurance.  Charles owns 100% of a company now worth $8 million with $2 million of leverage that did not previously exist.

I’ll make no value judgments regarding these two treatments.  However, I will suggest that if you have life insurance in connection with a buy-sell agreement, differences of this magnitude call for the parties to discuss and to understand what they are agreeing to in the negotiation.  The results are significantly different for both Harry and Charles under Example 1a and Example 1b.

What I can say from multiple experiences is that if the documentation linking life insurance to the buy-sell purchase is not clear, the estate of a selling shareholder under similar conditions as this example will likely argue that the life insurance was intended to be a corporate asset.  The estate is selling and desires the highest possible price.  Naturally, the company and a selling shareholder would likely desire that the insurance be treated as a funding vehicle.  Litigation can, and has before, result.

Three Large Owners: Example 2 (a and b)

In the second hypothetical example, we have three owners, Harry Charles and William. Harry owns the largest share (40%), and Charles and William own 30% each.  No one owner is in control of the business, so at least two owners must agree on significant decisions, and any two owners can jointly exert control.

Example 2a assumes that life insurance is a funding vehicle and the proceeds are not included in value for purposes of the buy-sell agreement.

In this example, William, a 30% owner died.  William’s share of value excluding life insurance proceeds is $3 million and the life insurance on his life is $3.6 million (Lines 5 and 6).  The company redeems his shares (Lines 9 and 10, and there are 70 shares remaining outstanding (Line 11).  Note (Line 12) that Harry’s share of ownership increased from 40% to 57.1%, so the operation of the buy-sell agreement left him with legal control of the business.

This may have been an intended or unintended consequence, but it definitely changes the working relationship between Harry and Charles relative to the non-control situation that existed prior to William’s death.

As in Example 1a, William’s estate received the pro rata share of pre-insurance value, or $3 million.  We’ve already noted the change of control.  Now look at the post-life insurance values for Harry and Charles, which increase more than 50% each relative to pre-transaction (Lines 13 and 15).  Harry’s value rises from $4 million to $6.1 million, and Charles has a similar increase, rising from $3 million to $4.5 million.

In Example 2b, life insurance is considered to be a corporate asset and the life insurance proceeds are included in value for purposes of the buy-sell agreement.

In Example 2b, William is still the owner who died.  Life insurance proceeds of $3.6 million are received by the company (Line 6), which would seem to be sufficient to pay the $3 million of value found for William’s estate on Line 3.  However, the life insurance is added to value in this example.

William’s estate shares in 30% of the $3.6 million of life insurance proceeds, so the estate is owed $4.1 million for its shares.  As a result, the company must borrow $480 thousand in addition to the life insurance proceeds of $3.6 million in order to purchase William’s shares from his estate for $4.1 million (Line 10).

In Example 2b, both Harry and Charles receive their pro rata share of the increased value attributable to the life insurance proceeds, so their values increase some 36% (as did William’s shares).

As in Example 2a, the operation of the buy-sell agreement shifted control of the business to Harry.

There is another alternative that we did not show.  Had Harry died owning 40%, Charles and William would have equal 50% ownership interests.  The results would have been numerically different but conceptually the same.

Concluding Thoughts on the Different Treatments

We have not covered all possible ownership situations, or all possible life insurance situations.  However, the examples above provide insight into the differences that the two treatments for life insurance proceeds can have on the parties to buy-sell agreements.

After thinking about the potential impacts of the different treatments of life insurance, we put together a preliminary, qualitative analysis of certain positive and negative or potentially negative aspects for consideration.  This chart is a work in progress, so if you have suggestions for additions, please let me know.

Readers can draw their own conclusions.  We make no value judgments about the differences in treatment above in either Example 1 or Example 2.  However, we do suggest that owners of companies with buy-sell agreements and associated life insurance companies should make themselves aware of the potential effects on ownership transfer and wealth transfer that might occur if the agreements are triggered.

Looking at the charts above, there is a certain rationale, particularly when life insurance is considered as a funding vehicle and not included in value, for instructing the appraiser to normalize earnings in the valuation process for the cost of life insurance.  That suggestion might be to normalize for the cost of the deceased owner’s policy.  However, the logic could as well call for normalization of the cost of all policies supporting the buy-sell agreement.