Partnership buy-sell agreements
MR. WATSON: If the business is a partnership, there are two ways to fund the buy-sell agreement:
- cross purchase plan - partners buy policies on each other
- entity plan - business buys the policies
Cross-Purchase
MR. WATSON: Please listen carefully. Mr. A and Mr. B own a very succesful boat-building business. They are both married and their spouse's want nothing to do with the business should one of their husbands die.
MR. WATSON: Now, with a business, in a partnership, if one of the partners dies the business by law must come to a halt. The only way you can keep the business going is if the surviving partner buys the dead partner's wife out. Or take her on as a partner.
MR. WATSON: So the partners set up a buy-sell agreement. So we have a $200,000 business.
- Mr. A buys a policy on Mr. B. He is the owner, the premium payor, and the beneficiary of a life insurance policy on Mr. B's life for $100,000.
- Mr. B does the same to Mr. A.
It's called a Cross purchase arrangement. If Mr. A dies, Mr. B gets the money. Mr. B takes the money and gives it to Mr. A's wife and buys her out. She goes away, and Mr. A retains sole ownership of this business. Does that make sense?
STUDENTS: Yes.
MR. WATSON: How many policies are there?
STUDENTS: Two.
MR. WATSON: To determine how many total policies are involved, you use a formula. Know this!
- (N-1)N..........(N minus 1) times N, where N equals the number of partners. Ex. 8 partners. (8-1=7). 8 x 7= 56. What if we had five partners, how many policies would there be?
MR. WATSON: What if we had five (5) partners? There would be 20, each partner buying a policy on the other, 5 x 4 = 20.
MR. WATSON: Now, is the business a party to the insurance agreement?
STUDENT: No.
MR. WATSON: Why? Because who is buying the policies?
STUDENT: Individual partners.
- The business buys the policy
- Premiums are NOT tax deductible
MR. WATSON: With the Entity approach , we let the business buy the policies. We have a $300,000 business. Each guy owns 1/3 or $100,000 of the business. The business buys one on Mr. A, one on Mr. B, one on Mr. C, a total of 3 policies. If A dies, what's the business get? $100,000. They take $100,000 and give it to-
STUDENT: Spouse. Mrs. A.
MR. WATSON: What are we trying to do? Buy her out, get her to go away. If A dies, who gets the money? The business. What does the business do with the money? They give it to Mrs. A. Where does she go? Who cares? She just goes away. Two people end up owning the business. The end result is the same, but with fewer policies.
MR. WATSON: With the entity approach, if you have three partners, how many policies are there? 3. Let's try this again. The business is buying one policy on Mr. A, one policy on Mr. B, and one more on Mr. C. How many policies? Three.
MR. WATSON: How many policies with the cross-purchase plan? Six. How many with the entity? Three.
MR. WATSON: With the entity plan, is the business a party to the agreement? Yes. Because who's buying the policies? The business. Who is buying the policies with the cross purchase?
STUDENTS: The individuals.
MR. WATSON: Which one of these ways would be tax-deductible?
STUDENTS: None of them.
MR. WATSON: That's because it is not part of (cabbage) C, B, or G.