In typical business setup, it is common that there are a few business owners. The problem arises when one of the partners is incapacitated; incur a critical illness, dies. Another problem arises when the partner retires. By default, the estate of the deceased partner takes over the partner’s portion of the business. This will create the following problems:

• Beneficiaries of the deceased partners become the new partners of the business.
• These new partners may not be experienced in running the business;
• Existing partners have to work with these new strangers;
• These new partners may have their own style of running the business;
• These new partners could be competitors;
• These new partners may not be qualified to be partners in a professional partnership;
• These new partners may not be keen to run a business and hence may prefer cash rather than being an owner of a business;
• These new partners who could be the family of the deceased has cash flow problems and prefer to have cash and not subject themselves to on-going business risks; 

A common way to overcome such problem is to create a Buy-Sell agreement among the business owners. A buy-sell agreement is a buy-out agreement which parties concerned are obligated to buy out another partner upon certain triggering events. In a simple two-partners situation, Partner A and B signs a buy-sell agreement promising a buy-out of the other partner’s share of the business in the event of the other partner’s incapacitation or death. The funding is usually done through a third party life insurance contract.

For illustration, Partner A buys on life of partner B. Similarly partner B buys on life of partner A. Say Partner A dies, the life insurance for which A is insured will be used to buy out A’s share of the business. If there are N partners in the business, there will be N * (N – 1) combination of life policies. This is known as Cross Purchase Agreement. For large number of partners, it is going to cause great headaches in administration and needless to say the insurance adviser is going to have hard time as well. A simple way is to use Entity Purchase approach. For such a case, the business itself is the policyholders and it buys on the life of all the partners. In this case, there will only be N policies to buy assuming N partners in the firm. The issue for Entity Purchase approach is that the business itself has to be a legal entity.

The Cross Purchase Agreement has another disadvantage. Partners in the firm may have doubts as to whether the buy-out will really be honored. This suspicious is not trivial. Take for example the simple 2 partners situation as mentioned above. Partner A dies. The life insurance insuring A is first paid by the insurance company to B since B is the policyholder. However, B may decide to keep the proceeds to himself refusing to pay to the estate of A. As a result of this, A’s estate inherited the unwanted share of the business and in the meantime suffers great financial distress due to the lost of A’s future income stream to support his family. A’s estate will have to sue B in court. This incurs high cost, high stress and not beneficial to any parties except the lawyers.

To get around this problem, one way is to create a single Discretionary Trust. This is how it works: Partner A and B buys the necessary life insurance on their own life. They then assign the policies through an absolute assignment to the Trustee. The Trustee is a neutral third party preferably a professional corporate trust company. A and B (who are also settlors in this case) are the beneficiaries of the trust. If Partner A dies, the Trustees will first receive the insurance proceeds from the insurance company (because the Trustee is the policyholder now). The Trustee would in turn pay to the heirs of A in exchange for A’s share in the business to remaining partner B.

The single Discretionary Trust creates another problem: The settlors are also the beneficiaries. This is not good for asset protection. Another way is to setup a multiple discretionary trust. Here is how it works: Setup a Discretionary Trust 1 with the Settlor A and Beneficiary B. The trust property is the policy insuring A’s life. Similarly setup Discretionary Trust 2 with the Settlor B and Beneficiary A. The trust property is the policy insuring B’s life. If A would to die, the Discretionary Trust 1 would simply pay to B and the trust wound up. If A would to go bankrupt, the policy insuring A’s life is still intact because the policy has already been assign absolutely to Trust 1 and that the Settlor is not the beneficiary (creditors may clawback a period of 5 years).

The entire buy-sell arrangement can be a big project. First it involves the consent of all partners to agree to the plan. Secondly, an accountant is likely required to provide a fair "value" of each partner's share of the business. Third, a lawyer is required to draft the agreement. Fourth, a financial adviser is required to source and submit the preliminary underwritings for a competitive life policies. Preliminary underwritings are required because the insured may not be in good health (thus causing complications to the agreement) and that some insurance companies are not been keen to insure large amount especially if it is a low profit-margin life policy. Fifth, a professional trust company has to be engage to be the Trustee and to draft the Trust Deed. The entire project need to be coordinated by a single indvidual. For a fee basis, I am able to provide this service to business owners as the Coordinator.

There are times which the buy-out is not necessarily just depends on incapacitation or death. Many partners would retire eventually. If they would to retire, they may want to sell their share of the business and enjoy their retirement with their proceeds. However, if the sale of their share of the partnership is sold to outsiders, this can cause problems to existing partners because of potentially unknown new partners. Another way is for existing partners to buy out the share of the retiring partners. In such a case, life insurance cannot be used since the happening of the event is not insurable (there is no death, TPD or critical illness).  If the fund is from one’s own saving, it can cause great cash flow problem because the capital can be huge. There are solutions for this and if any business owner is keen to hear of alternatives, I will be please to provide a consultation service for a fee.