Every insurance agency needs to have a written perpetuation plan. If there is more than one owner of the agency, it is absolutely critical that you have a valid, enforceable “buy-sell” agreement. In corporations this is known as a Shareholders’ Agreement, limited liability companies have a Members’ Agreements, and partnerships have a Partners’ Agreement. Regardless what you call it, at a minimum the agreement should address death, disability, retirement, involuntary termination of a shareholder, and involuntary conversion in situations such as divorce or bankruptcy.
From purely a funding perspective, death seems to be the easiest of these events to deal with. Just buy a life insurance policy and funding is taken care of. However, structuring the insurance incorrectly can cost the surviving shareholders significant money.
Classifications of Stock
What percentage of the agency do you own? It seems like a simply question but surprisingly, many people answer incorrectly because they don’t understand how stock can have different classifications:
- Authorized: When a business incorporates, the Articles of Incorporation state the number of shares authorized. This is the maximum number of share that the business can issue without amending the Articles of Incorporation.
- Issued: The corporation issues stock to shareholders. While the number of shares issued can equal the number of shares authorized, it is usually a good idea to leave some shares authorized but unissued in case the corporation wants to issue additional shares in the future.
- Treasury Stock: These are the issued shares that the corporation has bought back from shareholders. They can be reissued in the future, just like authorized but unissued shares.
- Outstanding Stock: Outstanding stock equals the issued stock minus any treasury stock.
A shareholder’s percentage ownership is equal to the number of shares the shareholder owns divided by the total outstanding stock.
Example: Bob, Joe and Fred start an agency from scratch, and the articles of incorporation authorize 10,000 shares. The corporation issues 500 shares to each of the three partners (1,500 total shares issued) each of whom owns one third of the agency. A few years later Fred retires and the corporation buys back Fred’s shares.
The status of the stock at this point is:
Issued & outstanding 1,000
Treasury Stock 500
Bob and Joe still each own 500 shares but now they each own 50% of the corporation since treasury stock is not factored into percentage ownership.
Life Insurance Ownership
Depending on how you have structured your Shareholders Agreement and Life Insurance, you either have a stock redemption agreement or a cross-purchase agreement.
In a stock redemption agreement the corporation owns the policies, is the beneficiary of the proceeds, and uses those proceeds to buy back the stock of the deceased from the estate of the deceased. This stock then becomes treasury stock.
Assume the corporation is worth $2 million and the corporation has a $1 million life insurance policy on Bob and a $1 million policy on Joe. Joe dies. The $1 million life insurance proceeds go to the agency which then pays the $1 million to Joe’s estate. Joe’s 500 shares now become treasury stock. Although Bob still owns 500 shares, he now owns 100% of the agency since treasury stock is not outstanding.
A few years go by and Bob sells the agency for $3 million. The entire $3 million is taxable.