Buy/Sell Life Insurance Agreements

Security for Your Business and Loved Ones

How does a Buy Sell Life Insurance Agreement actually work?

When taking out a buy/sell life insurance agreement, business partners purchase life and Total Permanent Disability insurance policies on each co-owner. In the event of one of the co-owners death or Total Permanent Disability, the other co-owners will be paid a lump-sum benefit that is then paid to the deceased’s surviving family members or the disabled co-owner. This payment allows the owners to acquire the share of the co-worker who has passed away while compensating the deceased family members or disabled co-worker

Why do people have buy and sell insurance agreements in place?

A buy and sell agreement is an integral part of a business succession planning process. When a partner is unable to continue running the business due to death or disability, a buy and sell life insurance agreement can protect the business, especially for the surviving owners. For most businesses it can be difficult to fund the buyout of the departing partners’ share which can result in a forced sale of the business or having next of kin that has no idea about working in the business taking over the share.

What are the key benefits?

Mutual benefit Not only does the family of the deceased benefit through this agreement, but the company does not experience any financial loss

Extends cover to serious illness and injury. Buy-sell life insurance can also be used to cover total permanent disablement or serious medical trauma

Rather than being forced to sell the business the remaining owners take over the share of the departed co-owner

The remaining owners don’t have to go into further debt to pay out the departing owner or their family

Key components of a buy and sell life insurance agreement.

Some of the main inclusions in a typical buy/sell life insurance agreement include:

Guarantee to buy the owner’s shares: The trigger events for a buy/sell agreement are always mentioned in the agreement and all the owners offer a guarantee that the shares of an owner will be purchased if any of the trigger events occur.

Purchaser of the owner’s shares: The agreement will also mention who has to buy the shares of the departing owner. The remaining owners may be bound to purchase the shares of the departing owner, or the company itself may be required to affect a buyout of the shares.

Valuation of the departing owner’s interest in the business: One of the main features of a buy/sell agreement is the valuation of the shares of the departing owner. The interest is typically valued as per the market rate of the shares at the time the trigger event occurred. Since most businesses differ in valuations over the years, the valuation of the shares of the owners is typically reviewed and re-calculated at least once every year.

How to fund the buyout: The buyout of the shares of the departing owner is typically funded through life insurance policies on the owner’s lives. These policies generally include total and permanent disability and trauma cover in some instances.

Determine the value of your business for the purpose of buy/sell life insurance agreement.

There are three types of valuation methods to help determine the value of your business for a buy and sell life insurance agreement:

Current market value

The Australian Taxation Office (ATO) will most likely consider the validity of a business interest transfer under a buy and sell agreement when it occurs at market value. Therefore, it may be reasonable to utilise current market value as the main valuation method and it is essential that this value is up-to-date, at least on an annual basis.

Current market value with indexation

You also nominate the sums insured based on the current market value of the business and keep up with changes of business value amount overtime by having them indexed to inflation or by the anticipated growth rate of the business.

Formula-based valuation

The business owners/partners/executives can also use a different approach by using a formula-based valuation method. This formula should reflect an industry standard and appropriate for the specific business. The value of the business over the years must also be reviewed by using this formula and it is important that the business owner are subjective when assessing whether or not the result (value) is realistic.

In addition, it is essential to have the business accountant conduct additional assessment on the valuation and provide a confirmation on whether or not it is acceptable on ordinary commercial terms, which may be an underwriting requirement depending on the nominated sums insured.

How much cover should I obtain for a buy and sell life insurance agreement?

To determine the level of cover that you and your business partner/s may need, consider the value of each owner’s share of the business. This value amount should generally reflect the sum insured on the buy and sell life insurance agreement. It is important that the business owners review this amount on an annual basis to ensure adequate cover is in place.

For example, if the business has two owners and each has an equal share of a business with a value of $2 million, the amount insured on the life of each partner should be $1 million on a buy/sell life insurance agreement that will provide cover for death, TPD and possibly trauma.

Consider the benefits of buy and sell life insurance agreement for your business

Uncertainties, such as death, illness, and injury, can greatly affect the financial well-being of your business. You, including your partners, are exposed to the risk of significant financial loss should the other suddenly die or become disabled. However, with a buy/sell life insurance agreement in place, you can eliminate such risk and ensure smooth business transition, even in difficult times.

Buy/sell agreement is a convenient and hassle-free solution for business owners and their loved ones while preserving the continuity of the business.

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