Guides
Business succession planning and the insurance that funds it
How a succession plan uses buy-sell agreements, life and disability insurance and key person coverage to transfer a closely held business smoothly.
Succession planning is the process of deciding who will own and run a business after the current owners die, become disabled, retire or leave, and then arranging the cash to make that transfer happen. Insurance is not the plan. It is the funding for specific events within the plan: death and disability of an owner, and the loss of a key manager. A plan without funding often leaves heirs and surviving owners in a forced sale.
Start with the events, not the products
Owners tend to start by asking for a type of policy. The better question is which events would force a change of ownership or leadership, and who has to pay whom in each. The common triggers are:
- Death of an owner.
- Disability of an owner.
- Retirement.
- Divorce of an owner, which can put shares in a spouse's hands.
- Voluntary exit, bankruptcy or loss of a professional license.
- A dispute that leads to a deadlock.
Each event needs an answer on four points: who may or must buy, at what price, on what payment terms, and where the money comes from. Insurance answers the fourth point for death and disability. Retirement and voluntary exit are not insurable events, so they need installment notes, reserves or outside financing, all of which the agreement should address.
The legal core: the buy-sell agreement
A buy-sell agreement is the contract that sets those answers. See Funding a buy-sell agreement with life insurance after Connelly for how it is funded, and cross-purchase vs entity redemption buy-sell plans for the structure choice. In a cross-purchase plan, each owner buys the departing owner's shares. In an entity redemption, the company buys them. A hybrid gives the company the first option and the owners the second.
How entity-owned policies interact with company valuation is covered in Funding a buy-sell agreement with life insurance after Connelly, so we do not repeat it here. The agreement should be reviewed when the company's value, ownership or tax status changes. An agreement signed in 2012 and never updated often has a stale price formula and out-of-date insurance. The buy-sell agreement funding calculator is a starting point for modelling funding needs.
The insurance layers
| Exposure | Coverage | Who receives the money |
|---|---|---|
| Owner dies | Life insurance | Surviving owners or the company |
| Owner disabled | disability buy-out insurance: funding a buy-sell when an owner is disabled | Surviving owners or the company |
| Key manager or rainmaker lost | key person insurance: protecting the business from a loss of talent and key person disability insurance: protecting the business when a leader cannot work | The business |
| Fixed expenses during an owner's disability | business overhead expense insurance: what it pays when an owner is disabled | The business |
| Funding deferred promises to executives | COLI, see COLI and BOLI explained: corporate and bank-owned life insurance | The business |
Each layer addresses a different loss. The owner's death requires purchase money. A manager's loss requires working capital. Both are real, and mixing them leads to underinsurance.
Family businesses
Where the next owner is a child or an employee rather than a co-owner, there are more design questions.
- Equalizing heirs. If one child enters the business and others do not, life insurance on the owner can supply an inheritance for the others while the business passes to the successor. That equalization is an estate-planning question, so involve an estate attorney.
- Transfers over time. Gifts and sales of shares during the owner's life are often combined with buy-sell funding at death. The tax consequences depend on valuation and entity type.
- Estate liquidity. An estate with a large business interest may owe estate tax on an illiquid asset. Life insurance owned by an irrevocable trust, rather than the owner, can supply cash outside the taxable estate. Setup is a legal matter, and a policy transferred into a trust within three years of death can be pulled back into the estate under IRC 2035. Ask counsel.
- Employee ownership. Selling to employees, through installment sales or an ESOP, needs funding for the owner's exit and a plan for any life insurance on the owner.
Taxes that shape the plan
The following federal rules recur. Confirm each with a CPA or attorney.
- Life insurance death proceeds are generally income-tax-free under IRC 101(a), but the transfer-for-value rule in 101(a)(2) can limit the exclusion if a policy changes hands for value. Transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer are exceptions.
- For employer-owned policies, IRC 101(j) requires notice and consent, and Form 8925 is filed annually. See Employer-owned life insurance: notice and consent rules under IRC 101.
- Premiums are generally not deductible when the payer is a beneficiary (IRC 264(a)(1)).
- Entity-owned policies can affect the value of the company, and an entity redemption does not give the surviving owners a stepped-up basis in the purchased shares the way a cross-purchase does. Both are CPA topics.
- Deferred compensation promised to the departing owner or a manager is a liability a buyer will account for. See nonqualified deferred compensation and corporate-owned life insurance.
Hypothetical example
Say three partners own a commercial landscaping company valued at $6 million. Their buy-sell requires the survivors to buy a deceased partner's share at a formula price, updated each year by agreement. The partners hold only $1 million of life insurance on each in an entity redemption plan, half of each partner's $2 million share, so the first death leaves a $1 million gap. A disability trigger exists in the agreement but has no insurance behind it. After the review the partners increase coverage to match the valuation, add disability buy-out policies, and buy key person coverage on the sales director. The agreement is amended so the valuation and the insurance are revisited each year. The numbers are invented for illustration.
A review checklist
- Does a signed buy-sell exist, and was it reviewed in the last two years?
- Does the price formula reflect current value?
- Are death and disability both funded, and do the definitions match the policies?
- Who owns each policy and who is the beneficiary?
- Are key people, not just owners, covered?
- Is there a continuity plan for operations in the interim (writing a business continuity plan: a step-by-step guide)?
- Have the owners' estate plans been coordinated with the agreement?
- Are lenders' assignments and covenants consistent with the plan?
Key takeaways
- Succession planning is an agreement and a funding plan; insurance funds death and disability events but not retirement or voluntary exit.
- Identify triggering events and the answers to who buys, at what price, on what terms and with what money.
- Use different coverage for different exposures: owner buyout, key person and overhead.
- Review the agreement and coverage amounts whenever value, ownership or tax status changes.
- Coordinate with a CPA and an estate attorney, since tax and legal structure drive the design.