Business partners do the responsible thing for one another, their families, and their employees when they craft buy-sell agreements to protect the business in the event one dies or becomes disabled. However, a buy-sell agreement — usually funded by life insurance policies — may not cover all the bases if there is an outstanding business loan on the books at the time of such an involuntary management change.

Why is this? The answer lies in little-read clauses in most standard commercial bank loan agreements, spelling out which situations constitute a default and will trigger a demand for immediate repayment. When businesses take on bank debt — whether to fund growth, to update equipment, or to get over financial hurdles — the basic terms of the loan are generally well understood and followed carefully. However, many business borrowers fail to understand terms that fall into the 'fine print' category. One of these may be that a change in key management, such as a death, can constitute a default — even if payments are right up to date.

Whether this becomes a reality is at the lender's discretion. But, if a bank decides to call a loan when a partner dies, the consequences can be dire. To cover the loan, the lender can attach the proceeds of the life insurance policy intended to fund the buy-sell agreement. This can leave the surviving partner unable to meet the terms of the agreement and place the deceased partner's family at financial risk. If the life insurance policy on the deceased partner is not sufficient to repay the loan, the effect on the business can be devastating.

The risk in such situations varies depending on the way the buy-sell agreement is structured. Let's look at three popular corporate succession plans and how they would fare under the scenario outlined above.

Entity buy-sell

This scenario, while easiest to structure and fund, offers the greatest risk in the event of a bank loan call. In this type of agreement, the business owns the life insurance policy, pays the premiums, and is the direct beneficiary of policy proceeds. This makes it easy for the bank to exercise the right of offset, since the company is also the borrower.

Cross-purchase buy-sell

This is somewhat less risky, but far from ideal. To illustrate the point, let's assume that a company borrows $1 million, and that $1 million is also established as the value of the business for purposes of the buy-sell agreement. Smith buys a $500,000 insurance policy on Jones's life. Jones does likewise. Smith dies, and Jones receives the $500,000 payment from the life insurance policy, which he deposits in his bank account. The lender decides to call the loan, and while the bank can't directly offset the funds, Jones is left in an untenable situation. He has $500,000, is guarantor on a $1 million loan, and owes $500,000 to his partner's estate.

Trusteed cross-purchase buy-sell

In this case, the life policy on Smith and Jones is purchased by a third-party buyout trust. In the event of one partner's death, the trustee submits the death claim and receives payment. The trustee then redeems the allocated shares on behalf of the surviving partner and pays the estate of the deceased partner. This leaves the bank out of the direct payment loop, but still doesn't solve the problem of paying off the loan.

The way partnerships can alleviate the risk inherent in buy-sell and corporate loan agreements is relatively simple: The company can purchase an inexpensive term life insurance policy to cover the loan. This protects both the partners and the business and helps facilitate succession and assure the company's future.