Using Life Insurance to Fund a Business Buy-Sell Arrangement

Cornell University

Using Life Insurance to Fund a
Business Buy-Sell Arrangement

by Loren W. Tauer
Department of Agricultural, Resource,
and Managerial Economics Cornell University

Many successful businesses, including farms, are closely held, with only a few owners.What happens to these businesses if one of the principal owners dies?Do they continue?Often the remaining owners can manage the business quite successfully.Their problem is the financial ability to buy the deceased owner’s share of the business from the estate or heirs.A solution might be a buy-sell arrangement funded with life insurance.

A buy-sell arrangement for co-owners to purchase each other’s business property is often suggested for closely held businesses.Upon the death of an owner, the mechanism is in place for an orderly transfer of ownership to the remaining owners, since contract negotiations had previously occurred when the arrangement was drawn.Buy-sell arrangements typically include details concerning who has the option to buy from a seller (including an estate), how the sales price is established, and how the transfer may be financed.If the buy-sell is written for the death of an owner, then life insurance becomes a financing option.

Both life insurance and heir or third-party financing can be used to transfer the business to a continuing operator upon the death of a property owner.A child who operates a business owned by a parent can purchase life insurance on the parent to finance the property purchase from non-business heirs.Life insurance proceeds can similarly fund a partnership or corporate buy-sell arrangement.

Insurance premiums are not tax deductible but the proceeds are free from income tax.Since the decedent never owned the policy, the proceeds are not included in his estate.Life insurance premiums begin immediately and cease at death (or sooner) when the insurance proceeds are used to purchase the business.In contrast, the cost of heir or third-party financing will not begin until death and will continue until payments are completed.

The decision whether to use life insurance to fund a buy-sell arrangement would be simple if the purchaser knew with certainty when the insured will die.If death will occur within a few years, then the use of life insurance would be the low-cost option.If death will occur many years hence, the purchase of life insurance would be foolish until shortly before that death.However, death is not known with certainty.

I have studied this decision, incorporating uncertainty into the decision (Tauer 1987, Tauer 1985).Whether to purchase life insurance was found to depend upon the unique characteristics of the business and the individuals involved.Important characteristics are the cost of the insurance, the age of the insured, and the degree of risk aversion of the purchaser.

Although the decision to buy insurance is unique to each situation, some general results were found.First, if the individual is not risk averse, then life insurance should not be purchased.The cost of insurance is always greater than the expected loss since insurance companies need to charge sufficient premiums to cover administrative and other costs in addition to their expected payout.The more risk averse an individual is, the greater percentage of the buy-sell arrangement that should be funded by life insurance.

Second, the more costly the life insurance premium, the less insurance that should be purchased.However, even if the insurance is relatively expensive, the buy-sell arrangement should be at least partially funded with life insurance.This allows diversification in financing of the buy-sell.Most should use some life insurance funding even if it is costly, but very few should completely fund with life insurance, even if it is low cost.

The age of the insured has little impact on the decision.Premiums are higher on older individuals but then the expected loss is greater.If the person buying the insurance has limited funds, however, less insurance should be purchased because those limited funds may have higher value used elsewhere.

To summarize these results, Tables 1 and 2 show the percentage of the buy-sell purchase to be funded with life insurance for a 40-year-old insured and a 60-year-old insured at four different annual term insurance premiums and three different levels of risk aversion.If the insurance premium is $2.39 per $1,000 of insurance for an insured of age 40, a slightly risk averse purchaser should only fund 60% of the buy-sell with life insurance.In contrast, if the insurance cost is $3.82, then only 10% of the buy-sell should be funded with life insurance.

A decision also needs to be made whether to purchase whole or term insurance.The insurance industry prefers to sell whole-life policies. Yet, research has shown that guaranteed renewable term insurance is the better buy for consumers (Warshawsky).

Small businesses often do not utilize life insurance in buy-sell arrangements.Several explanations are possible.Many owners are myopic and do not plan ahead.Others are averse to the thought of planning for death, even a partner’s death.Even if a buy-sell arrangement exists, a business person may place a lower subjective probability on the death of a partner.This would decrease the use of life insurance.

Some may be averse to a co-owner or the business purchasing and benefiting from life insurance on their lives.Others are never offered low-cost life insurance policies.Finally, many have insufficient funds to purchase life insurance, although it may be the optimal decision without the cash-flow constraint.Survival or growth of the business requires reinvesting all earnings.The fact that insufficient cash or cash flow exists to purchase the business, if necessary, is not relevant since that problem is not imminent.

Table 1

Percentage of the Buy-Sell Purchase to be Funded with
Life Insurance for a40-Year-Old Insured
 

Aversion to
Term Insurance
Annual Premium
per $1,000 of Risk*
  $2.10 $2.39 $2.86 $3.82
Slight 80% 60% 20% 10%
Moderate 100% 80% 60% 40%
High 100% 100% 80% 70%

*Pratt’s relative risk aversion of .5 (slight), 1.0 (moderate), and 2.0 (high).

Table 2

Percentage of the Buy-Sell Purchase to be Funded with
Life Insurance for a 60-Year-OldInsured
 

Aversion
to Risk*
Annual Premium
per $1,000 of Term Insurance
  $14.52 $16.50 $19.80 $26.40
Slight 80% 60% 20% 10%
Moderate 100% 80% 60% 40%
High 100% 100% 80% 70%

*Pratt’s relative risk aversion of .5 (slight), 1.0 (moderate), and 2.0 (high).

References

Tauer, L.W.“Life Insurance Funding of Buy-Sell Arrangements to Purchase Business Property from Heirs,” North Central Journal of Agricultural Economics, 9 (1987): 237-246.

Tauer, L.W.“Use of Life Insurance to Fund the Farm Purchase from Heirs,” American Journal of Agricultural Economics, 67(1985): 60-69.

Warshawsky, M.“Life Insurance Savings and the After-Tax Life Insurance Rate of Return,” The Journal of Risk and Insurance, 52(1985): 585-606.