When people get into business with each other their view is that the business will be extremely successful and all the partners will be around to see it through. Most entrepreneurs believe they and their families will benefit in many ways, especially financially. As much as we might hope for the best, what happens if one of the partners dies? What if one becomes disabled? How does the business continue and how does the partner that is left to run the business make sure that the disabled partner or the heirs of a deceased partner are properly compensated? The key is having a buy sell agreement.
At the start of a new business the partners should draft a document that spells out how they go about buying out a disabled partner or paying out the spouse or family of a deceased partner. Ideally, there is an agreed upon value, or how to calculate the value, of their business. This may sound fine on paper but what happens when the agreement is called into action. How do you buy out a disabled partner or pay out after the death of a partner? Not only is it important to have a plan and an agreement but it's equally important to fund the plan with Life Insurance or Disability Insurance.
Let’s deal with the death of a partner as an example. Joe and John Smith are brothers who go into business with each other, equally (50/50). For example sake they estimate the business is worth 1 million dollars. Each of their shares is worth 500,000. If Joe suddenly passes away, John now has to come up with 500,000 to pay out Joe’s heirs. Does John have 500,000 cash to pay out the heirs? Maybe, maybe not. Does he want to take it out of profits from the company to pay the heirs? I think he would prefer not to. Ideally, Joe and John set up a funded Buy Sell agreement and the Company owns $500,000 of Life Insurance on each of them. The Company pays the premiums and the Company is the beneficiary. Joe’s policy is paid to the company and in turn the Company uses that money to pay the heirs. The heirs get full value of Joe’s share and John becomes sole owner. This method provides instant cash for the Company eliminates the need to borrow any money and frees up capital in the Company for normal business use.
What is the Capital Dividend Account?
When a Company owns life insurance on the owners and one of them passes away, the proceeds of the life insurance will be run through the Capital Dividend Account (CDA) and paid out to the heirs. The CDA is not an account that shows up on a balance sheet it is a notational account that is really only important for tax purposes. The Company declares a tax free dividend to pay off the heirs and the cash comes from the life insurance used in the buy sell agreement. The money is paid to the Company tax free and then out to the heir’s tax free. The detailed inner workings of CDA will have to be left for another day.
What happens in case of disability?
When a business partner becomes disabled and will not be coming back to work, how does the other partner come up with money to pay out the disabled partner? Disability insurance, of course. In the same scenario, above, let's say Joe is disabled. Ideally, there would be disability plans in place to pay out Joe monthly or annually equal to an agreed upon price. The ownership of the disability plans can be set up so that the Company owns it or that the individual owns their own plan. It will depend on what the owners feel is the best arrangement. The payout may start 365 days from onset of disability. To have a disability buy out kick in 30 days after disability may not make sense because the disabled partner may recover in the short term and come back to work. The partners want to make sure that the disabled partner is not coming back to work.
Here, we have two simple examples of a properly funded Buy Sell Agreement. Having a properly funded agreement will make sure the business continues to flourish and that the partner or his or her heirs are properly compensated for the hard work that he/she put into the Company.