Valuing Life Insurance in Buy-Sell Agreements Takes Finesse

Should life insurance be considered a repurchase funding asset or a corporate non-operating asset and in what situations?

In a straight-forward analysis, Z. Christopher Mercer, ASA, CFA, ABAR reviews the proper protocol for valuing life insurance in buy-sell agreements that avoids back end surprises for the shareholder and remaining shareholder(s), as well as the company.  Providing several key scenarios as examples, Mercer lays out a valuation vehicle that truly plans for the future.

What is clear from this example is that the issue of the valuation treatment of life insurance proceeds is far too important not to be addressed specifically in buy sell agreements.  If an agreement is silent on the issue and the life insurance proceeds are significant in relationship to the value of a business, rest assured that there will be an issue – probably litigation – when a significant shareholder dies.

With out-of-date fixed price agreements where value rises over time, the parties to that agreement make a bet that “the other guy” will die first.  And one of them will be right! With life insurance proceeds, there is something of a similar bet if life insurance is treated as a funding vehicle only.  In this case, however, the seller who dies first will get what his stock was worth before life insurance proceeds.  His only “loss” is in not sharing in the incremental asset created by the insurance.

Parties to an agreement may feel differently about this “loss” or incremental gain depending on whether a company is entirely family-owned or the ownership is comprised of unrelated parties. However, regardless of they feel about it, the Internal Revenue Service may have a say about the treatment of life insurance proceeds in family-owned businesses.

Although life insurance is an asset unrelated to the operation of a business, all parties involved must treat it with the same due diligence as any corporate investment or distribution.  

Z. Christopher Mercer, ASA, CFA, ABAR is the CEO of Mercer Capital based in Memphis, TN.  He can be reached at:  (901) 685-2120 / mercerc@mercercapital.com.