Funding Fundamentals

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Published by Scott Roberts, Director of Estate Planning


Aside from the basic structure of a buy-sell agreement, other factors are equally important.  For example, if the purchase upon death is mandatory, which is recommended, then adequate funding should be ensured.  This is typically done with life insurance to avoid a situation where a surviving shareholder is left with a large liability and no way to easily pay.  Careful consideration should also be given to whether a purchase upon disability is mandatory or not.  Since buy-sell disability insurance can be difficult to obtain in large amounts, a mandatory provision might leave the non-disabled shareholder similarly financially hampered.

Buy-sell agreements also create a valuation conundrum for many business owners.  On one hand, they want to set the purchase price high enough so they can ensure their heirs receive full value for their business interest.  On the other hand, they would prefer to set the value of their business interest low for estate tax purposes.  What many don’t know is that it is possible to peg the value of a business at a low, substantiated amount for estate tax purposes while also ensuring your family members receive a higher amount.


The brilliance of the technique to accomplish this “dual valuation” is its simplicity.  It all comes down to the simple ownership structure of the insurance policies funding the agreement.  But, first things first, the matter of valuation must be addressed.


As the conundrum referred to above reveals, a true valuation of a privately-owned company can be elusive.  It is common knowledge that a company’s value is often best expressed as a range, sometimes even a large range, due to various circumstances and uncertainties.  For example, one qualified appraiser may value a company at $20 million and another qualified appraiser may value the same company at only $12 million.  For a 50% shareholder, that is a difference of $4 million.


This inexactness of valuation provides a planning opportunity if, for example, the shareholder wanted his family to benefit from the higher valuation, but wanted to mitigate taxes at the same time.  In such case, the buy-sell agreement, an arm’s length agreement between business partners, could reasonably use the lower valuation substantiated by a qualified appraiser’s valuation report and a $6 million insurance policy could be obtained, which would be part of the taxable estate.  Meanwhile, another $4 million insurance policy, separate from the buy-sell agreement, could be obtained and owned in a life insurance trust.  In this way, the shareholder could ensure that $10 million would benefit the family while only $6 million would become a part of the taxable estate.  Assuming a 40% estate tax rate, the potential tax savings of this simple tweak to the structure is $1.6 million.


While not every situation lends itself to this method of funding a buy-sell agreement, a careful examination of all the opportunities with a qualified advisor is recommended.  And, in any case, careful consideration of mandatory buy-out provisions should always be part of the planning process.


This information is not intended as authoritative guidance or tax or legal advice. You should consult with your attorney or tax advisor for guidance on your specific situation.  LPL Financial does not provide legal advice or services.

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