Buy-Sell Agreement

In an entity (stock-redemption) buy-sell plan:

1. A.The government owns the policiesGovernment has no role in a private buy-sell arrangement. The parties are the business and its owners.
2. B.Each owner insures every other ownerThis describes the cross-purchase design, the genuine alternative and the easiest thing to confuse with the entity form. Under cross-purchase the owners hold policies on each other; under the entity form the company holds them all.
3. C.No insurance is usedInsurance is what funds the purchase, delivering cash at precisely the moment an owner dies. An unfunded agreement leaves the buyer hunting for money at the worst possible time.
4. D.The business owns the policies on each ownerCorrect - entity owns and redeems.

Why: The business itself owns the life insurance policies on each owner and buys back a deceased owner's interest.

A business wanting funds to buy out a deceased owner's share should:

1. A.Fund a buy-sell agreement with life insuranceCorrect - insured buy-sell provides the cash.
2. B.Do nothingLeaves the surviving owners owing the estate for an interest they may have no way to pay for. The estate needs cash and an operating business rarely has that sum sitting idle, which is exactly the gap the funded agreement closes.
3. C.Buy disability insurance onlyA disability buyout is a legitimate companion arrangement, so the instinct is not wrong in general. It pays nothing on death, however, and the stem specifies a deceased owner.
4. D.Rely on the estate to donate the sharesAn executor owes a fiduciary duty to the heirs and cannot give away estate property. The interest has to be purchased at fair value, which is precisely why the funds must be arranged in advance.

Why: Funding a buy-sell agreement with life insurance ensures cash is available to purchase the deceased owner's interest.

In an entity (stock-redemption) buy-sell plan, the life insurance policies are:

1. A.Owned by the business entityCorrect - the entity owns the coverage.
2. B.Owned by each owner on the othersThis is the cross-purchase structure, and it is the classic mix-up on this topic. In a cross-purchase each owner buys a policy on the others; in an entity plan the business itself is the single owner, payer, and beneficiary.
3. C.Not neededA buy-sell agreement is only a promise to purchase; life insurance is what funds it. Without policies in place the survivors or the business would have to find the purchase price from cash flow or borrowing at the worst possible moment.
4. D.Owned by the employeesRank-and-file employees are not parties to a buy-sell arrangement, which exists to transfer an ownership interest. Employee-owned coverage would be a personal or group benefit, not buy-sell funding.

Why: An entity buy-sell has the business own and be beneficiary of the policies on each owner.

Three equal owners of Halverson Millwork, a closely held C corporation, want life insurance to fund a buy-sell agreement so that a deceased owner interest is purchased from the estate. They are comparing a CROSS-PURCHASE structure with an ENTITY (stock redemption) structure. Which statement accurately distinguishes them?

1. A.Under the entity plan the surviving owners receive a basis increase equal to the redemption price, which is its main advantage over cross-purchaseThis is the cross-purchase advantage, stated about the wrong structure. In a redemption the corporation is the buyer, so no owner takes on new personal basis.
2. B.The entity plan requires six policies and the cross-purchase three, because the corporation must insure each owner twiceReversed. The entity needs only one policy per owner. Nothing requires insuring an owner twice.
3. C.Both structures require the same number of policies; they differ only in who pays the premiumsPremium payer does differ, but so does policy count. Cross-purchase needs n x (n - 1) policies because every owner insures every other owner.
4. D.Cross-purchase requires six policies here and gives the surviving owners a basis increase in the shares they buy; the entity plan requires three and gives the survivors no new basisCorrect on both dimensions: 3 x 2 = 6 policies under cross-purchase, versus one per owner under the entity plan, and only the personal purchasers get new basis.

Why: Under a cross-purchase plan each owner personally buys a policy on each of the other owners, so with three owners six policies are required, and the surviving purchasers receive a cost basis in the shares they buy equal to what they pay. Under an entity plan the corporation owns one policy per owner - three policies - and redeems the deceased owner shares itself, so the survivors acquire no new basis even though their percentage ownership rises.