For many small business partnerships, the death of one of the owners can pose a huge problem for the surviving owner(s). Dealing with grief is one issue, but dealing with the financial consequences is quite another. Using life insurance to fund a buy-sell agreement is one solution that many small business owners find very attractive.

A buy sell agreement is a contract where the surviving owners are required to buy the deceased’s interest in the business from the deceased’s heirs. The heirs are required to comply by the terms of the agreement by selling their inherited interest at a predetermined price. This method of dealing with the ownership stake of the departed is gaining in popularity for a number of reasons. Primarily, the business does not suddenly have to generate a large amount of cash to pay the heirs for their interest in the business. Another reason for its popularity is that family members are assured of receiving fair market value for their inheritance.

With a cross purchase agreement, each owner of the business will take out a life insurance policy on the other owners, with themselves being named as the beneficiary. Upon the death of one of the owners, the survivors will use the proceeds from the life insurance to pay the deceased’s heirs.

The advantages of this arrangement are many. A fair market value is determined well in advance and since the proceeds from life insurance are tax-free, there will be no income tax consequences. The proceeds usually arrive quickly, so lengthy waits for probate can be avoided. Additionally, the proceeds arrive outside the corporation and cannot be claimed by any creditors.

The drawbacks are that the insurance premiums are usually paid with pre-tax dollars and are therefore not tax deductible. Be sure to check with your insurance advisor, since in some states you can run the premiums through the corporation’s after tax revenue and have the proceeds distributed through the corporate dividend account, enabling you to claim a deduction and receive the benefits tax free.

Another possible disadvantage occurs if there is a wide difference in the age and health of the owners of the business. Older and sicker owners will have to pay higher premiums, or may even be refused coverage altogether. However these difficulties will be a known commodity and can be addressed in the legal contract of the buy sell agreement. As always, be sure to get professional advice before making any purchase.