Life Insurance in Buy-Sell Agreements

February 2011

Buy-sell agreements should address the disposition of life insurance policies when the need for coverage ends

A well thought-through buy-sell agreement is critical in any business that has multiple owners. Buy-sell agreements serve many purposes; they are generally structured to allow co-owners to agree, in advance, on how business ownership transfers will be addressed if one of the owners dies, retires, becomes disabled, gets divorced, files bankruptcy, wants to sell his interest, defaults on his responsibilities spelled out in the company’s operating agreement, and so on.

To spare the company and its owners from having to come up with large sums of cash to buy the interest of a departing member or his survivors, many buy-sell agreements call for the purchase of insurance that will fund the buy-out under certain circumstances, such as the death of an owner. Most policies are owned by the business or its owners, or they might be owned by a trust, an LLC or a partnership.

Dispute. But what happens when the need is no longer there for the insurance, but one of the parties wants to keep the policies in place? A recent Indiana court case, Hilliard v. Jacobs, 916 N.E. 2d 689, highlights the need for business owners to close the loop on ownership of life insurance policies that fund a buy-sell arrangement when such coverage is no longer needed.

In this case, two business owners bought a $2.5 million life insurance policy on each other to fund a cross-purchase buy-sell agreement. This is a common and prudent approach. The twist came when they sold their business to a third party. After the sale, Hilliard requested an exchange of policies. Jacobs refused and continued to pay premiums on the policy he owned. Hilliard filed a lawsuit requesting that the policy be either transferred to him or canceled, arguing that Jacobs no longer held an insurable interest in Hilliard’s life.

The court disagreed, noting that Indiana law does not require the presence of a continuing insurable interest.

It is noteworthy that the owners had two chances to address final disposition of life insurance policies before things elevated to a lawsuit. Their first opportunity was the buy-sell agreement itself. A second arose through a settlement agreement when the company was sold. It’s hard to tell from the reported case itself whether the parties tried to address the issue in either the agreement or through the closing documents of the business sale.

Lesson. For business owners and their professional advisors, this case carries an important lesson: Be sure that buy-sell agreements address the disposition of life insurance policies when the need for coverage ends. Or, alternatively, include language that gives an insured party the opportunity to acquire ownership of a life insurance policy that was originally intended for buy-sell funding purposes.

Note: The information in this article is general in nature and should not be relied upon as specific tax advice. To determine how adoption tax credits and exclusions apply to your situation, please contact a tax professional.