General Practice, Solo & Small Firm Division
American Bar Association
General Practice, Solo, and Small Firm Division The Compleat Lawyer
Fall 1997 copyright American Bar Association. All rights reserved.
Keyperson Insurance and Buy-Sell Agreements Protect Your Firm from Financial Disaster
BY EDWARD J. MOREHOUSE, JR.
Edward J. Morehouse, Jr., is a financial associate with EQ Financial Consultants, Inc., of the Equitable Life Assurance Society. He has a broad background in labor and employment law issues, industrial and labor relations, and pension/benefit matters. For more information on your firm's insurance needs, call 800/992-0790.
One of the best ways to help protect your firm from tumultuous times is through proper planning. Keyperson insurance and buy-sell agreements can help ensure a firm s survival and meet your estate planning needs.
When Brian White, senior partner of White & White, died unexpectedly of a heart attack, his firm could have drifted aimlessly without its leader. But instead, his practice sailed through the transition. Keyperson Insurance Benefits to the Firm
- The firm needs or desires to protect itself from the death of a key person.
- The firm wants to assure its creditors and customers of continuity.
- The firm needs surplus funds to help replace profits lost due to the death of a key person.
- The firm needs funds to recruit, hire, and train a replacement.
- The firm needs funds for a stock redemption agreement.
- The firm wants to own the policy and have a control over all rights in the policy, including access to cash values. Cash values are carried on the firm s books as a business asset and may be used as collateral.
- The firm wants cost recovery of its premium outlay (through tax-free insurance proceeds). Concerns for the Firm
- Possible alternative minimum tax consequences for C corporations.
- The firm gets no deduction for premiums paid.
- Premiums are paid with after-tax |firm funds.
- Proceeds may increase the total value of business interest includible in a deceased key partner's estate.
Insurance for Key People
How did White's firm manage to stay afloat after he was gone? A year earlier, White had purchased keyperson life insurance on his life to insure one year's profits. The result? The practice continues to flourish and provide for his family and staff.
Every law practice should consider keyperson coverage. This type of insurance protects a firm against various financial setbacks that can result from the death of a key lawyer in the practice. The key person could be you or anyone else critical to the firm's continued operation.
Keyperson coverage can provide enough cash to replace lost revenue due to the death of a lawyer, repay business loans, recruit and train a replacement lawyer, and otherwise keep the waters calm during a stormy transition.
Another advantage of purchasing
keyperson insurance is improving your chances for loan approval. Lenders look favorably on a firm with keyperson insurance since it shows responsible planning and makes it more likely they will be repaid.
How much keyperson coverage should you buy? That depends on the effect the key person's death would have on the practice. Although this may be difficult to determine, aspects to consider include the person's salary, industry knowledge, goodwill generated by the person, the cost of hiring a replacement, and the firm's outstanding loan balance. One rule of thumb is to buy three to five times the key person's salary. Another is to purchase a year's net earnings.
Entity Purchase Buy-Sell Plans Benefits to the Firm
- The firm is to be the owner, premium payor, and beneficiary of policies on the lives of its owners.
- The business is to use the proceeds of the policy to purchase a deceased owner s interest from his or her estate.
- Fair market value of the interest is to be established and liquidity for the owner s family/estate created.
- Simplicity is desired. The entity purchase plan requires fewer policies and less accounting than the cross-purchase plan if there are more than two owners.
- The business is in a lower tax bracket than owners, effectively lowering the cost of the plan.
- Pooling of premium shares is desired when there is an age disparity among the owners.
- An agreement is needed to continue the business after the death of an owner, free of conflicting interests.
- Survivors want a guarantee that funds will be available to purchase shares at the death of an owner.
- Stability is sought. Employees, lenders, customers, suppliers, and shareholders are more confident of business continuation after the death of an owner.
- No unreasonable compensation concerns as in the case when salaries are increased to pay life insurance premiums under a cross-purchase agreement.
- An unwanted forced sale is to be avoided.
- A smooth transition of control is desired.Concerns for the Firm
- Premium payments are nondeductible by the partnership.
- The value of the business interest, as specified in the buy-sell agreement, is includible in the partner s estate.
- Voting power could be unfavorably shifted at a partner s death.
- Insurance cash values and death benefits are subject to claims of company creditors.
- It can result in higher capital gains to surviving owners should interest be sold at a later date because no step up in basis is available.
- The firm s loss of the use of the premium payment. Buy-Sell Agreements
Thomas Black and his partner Phil Johnson worked hard to establish a thriving law practice. Then, unexpectedly, Johnson was killed in a plane crash. Such an event could have plunged Black into debt and caused the liquidation of the firm. But with a buy-sell agreement firmly in place, the practice was able to continue almost uninterrupted.
The agreement had established the value of the firm and the funds necessary for Black to buy out his deceased partner's interest. The law practice survives today, and Johnson's heirs were paid in full for their interest in the firm.
If a firm is a partnership or a closely held corporation, a properly funded buy-sell agreement is vital. When there is more than one partner, a buy-sell agreement allows the remaining partner(s) to purchase the business interest of the deceased, retired, or permanently disabled owner.
A buy-sell agreement funded by life insurance can accomplish the following:
- Help eliminate potential lawsuits stemming from the business valuation.
- Help assure the continuation of the business for the remaining partner(s).
- Allow the surviving partner(s) to maintain control of the firm by requiring the deceased partner's interest to be sold.
- Help assure that the partner's heirs are quickly paid in full for their share of the firm, even if the surviving partners are not able to run the firm successfully.
Typically, a buy-sell agreement can take two forms. In a cross-purchase agreement, the partners agree to buy each other's interests upon death, retirement, or permanent disability. You also can structure a stock redemption or entity purchase where the firm or partnership buys the departing owner's interest.
One advantage of a cross-purchase agreement is avoidance of the corporate alternative minimum tax (AMT), which the firm may be subject to if it purchases the policy and is the beneficiary. The corporate AMT does not apply to S corporations. If the departed partner is bought out under a cross-purchase agreement, and the remaining owners sell the firm, they generally will pay less income tax than if the agreement was a stock redemption plan.
One advantage of a stock redemption arrangement is that the firm, rather than the partners, pays for the insurance policy. Also, if there are a number of partners, a stock redemption is less complicated and may be less costly since fewer policies are required. (For example, under a stock redemption, the firm purchases one policy on each partner, while under a cross-purchase agreement each partner must purchase a policy on each of the other partners.)
Do You Need Keyperson Insurance?
You should consider purchasing keyperson insurance if any one of the following is true:
Professional Assistance Is a Must
- Your firm is likely to falter if you are no longer there.
- Your firm is likely to falter if another lawyer is no longer there.
- You do not have adequate funds to offset any losses until an appropriate replacement for the key person can be found.
Whether your practice is considering keyperson coverage, a buy-sell agreement, or both, it is important that the documents and policies be reviewed periodically to ensure that the valuation formula is current and that the plan is funded adequately. Cross Purchase Buy-Sell Agreements Benefits to the Firm
- There is to be an exchange of stock or business interest for cash/notes among partners or third-party buyers.
- Partners seek to establish a fair market value for their business interest.
- Partners/trust are to be owners, premiums payors, and beneficiaries of life insurance policies.
- Surviving partners wish to receive a step-up in basis in acquired interest, possibly resulting in tax savings at a later sale.
- Avoidance of family attribution concerns is desired.
- Life insurance cash values and death benefits are not to be subjected to the claims of company creditors.
- Premiums are to be paid by the firm, through a bonus arrangement, and treated as reasonable compensation to owners.
- An agreement is needed to continue the business after the death of a partner, free of conflicting interests.
- Surviving partners want a guarantee that funds will be available at the death of an owner.
- Stability is sought. Employees, lenders, customers, suppliers, and shareholders are more confident of business continuation after the death of partners.
- An unwanted forced sale is to be avoided.
- Life insurance proceeds are to be free from income taxation.
- A smooth transition of control is desired. Concerns for the Firm
- The value of business interest as stated in the buy-sell agreement is includible in a partner s estate.
- The partner s loss of use of premium payment.
- Possible unreasonable compensation concerns where salaries are increased to pay life insurance premiums.
- The partner may have difficulty in paying premium.
- The plan becomes more complex as the number of partners increases.