The Interplay Between the Funding Mechanism And the Valuation? 

What happens when life insurance proceeds are part of the funding vehicle of a buy and sell agreement (BSA).    

 Example 

 When a stockholder owner dies and life insurance payments are made, is the valuation of the stock being redeemed as part of the value of the company?   

The way life insurance benefits are treated in the buy and sell agreement (BSA), could lead to different estate treatment and income tax.    In both areas, the results can be dramatic.     

 Does the agreement tell the appraisers how to treat the life insurance benefits in their valuation?  Does the agreement provide for the company to issue a promissory note to a deceased shareholder, and what are the terms? 

 Keep in mind, the agreement is no better than the ability of the parties and/or the company to fund any required purchases at the agreed upon price.    An agreement that is silent on this issue is like not having an agreement.  

 Life insurance  

 Generally, life insurance premiums are not deductible, and the pass through of non-deductibility can create pass-through income for the shareholders of S corporations, and the owners of partnerships and limited liability companies.  Knowing how to treat the life insurance premium for tax purposes would be important information for you.  We suggest you discuss this with your CPA.  

 Although the life insurance premium is not deductible, the death benefits generally are tax- free, notwithstanding the alternate minimum tax treatment for C corps.  

Keep in mind the funding mechanism is not actually necessary to define the engagement for valuation purposes and has nothing to do with appraisal standards or qualifications. It provides the funding for the company to afford the value, and to make sure the selling stockholder receives the value.  In essence, it’s the mechanism to fund the liability of the contract, or at least part of it.   

Wants and Needs of the Buyer and the Seller- The normal push and pull!  

The seller wants the highest price and the buyer wants the lowest price.   Without a doubt the best time to set the price would be prior to a triggering event, when both parties are in parity and neither is the subject of the trigger.  It is the best time when both parties will be the most reasonable in setting the rules of the agreements as they are both fair minded in the negotiations.   

 Funding Methods 

1. Life Insurance:  In most cases life insurance will be the most inexpensive method for funding the death benefit part of the agreement, when comparing, self funding, and loans (including corporate promissory notes) to fund the liability, notwithstanding the ability to get a funding loan from a loaning institution.    In most of the comparisons I have done over the years, life insurance is the least expensive, most guaranteed, and the easiest method of funding for death benefit purposes. 

1. Corporate Assets: They would have to be accumulated for this purpose, and would likely be included in the valuation, and also would be subjected to taxes during the accumulation stage.  What if the death of the stockholder occurred early after the agreement?  Would there be funds available to fund the liability of the agreement, as there would be a lack of time to accumulate the necessary net profits for the funding?   

1. External borrowing: Depending on the company’s financial position, it may be possible to fund the purchase price by borrowing.  However, this should be negotiated in advance and before its needed.  Remember, the time to requests funds from an institution is when you don’t need them.  Also, on the other side of this funding element, is the possibility the loan covenant requesting the outstanding note balanced to be called in when there is a dramatic change in ownership and management.    The lending institution may be questioning the ability of the company’s future financial position and the ability to stay profitable.   

1. Promissory Notes:  If this is going to be used, the terms of the notes should be in the agreement.  Although cash payments are preferable to the seller.   

1. Combination of cash and promissory notes: Important to note:  Anytime capital is being used by the corporation, it is important not to unreasonably impair the capital of the business. Many state laws prohibit transactions that could impair capital and raise the question of insolvency.  

Without the mention of what funding mechanism is being used in the agreement to repurchase shares, lessens the value of the agreement.  Also, with stated funding, the economic or present value of the redemption price set by the agreement can significantly be reduced, because of inadequate interest or excessive risk leveled on the selling shareholder.   

Weak terms in the agreement of the funding mechanism diminishes the value of the agreement from the sellers prospective. However, terms that are too strong can taint the future transactions. What is clear is that it is essential for the parties to discuss the funding mechanism for the triggers of a BSA, keeping in mind both the sellers value position and the purchaser’s ability to fund the costs.