In Downturn's Wake, More Owners are Turning to ESOPs discusses some ways to incorporate life insurance into an ESOP transaction, including using life insurance to 1) fund the Repurchase Obligation, 2) fund non-qualified plans for key executives, 3) provide for the continuity of the business in the event of a key employee's death, and 4) provide a guarantee that the bank or seller financing will be paid in the event of death of the seller or other key employees:

So far, so good. But before proceeding a with an ESOP sale, the seller and successor owners have to decide how to fund a key plan provision: the repurchase of stock from departing employees.

In many instances, observers say, the preferred solution will be permanent life insurance. One reason is the vehicle's tax-favored wrapper: Policy cash values used to cover repurchase obligations grow tax-deferred. And flexible premium universal life insurance, the policy type most commonly used for an ESOP, generally offers a predictable rate of return.

Life insurance is also used to fund non-qualified plans for key executives, including deferred compensation plans, bonus plans, group carve-out plans and split-dollar life insurance plans, as well as to provide for the continuity of the business in the event of a key person's death.

"Usually, the most valuable assets in the company are managers with the intellectual capacity, experience or longevity needed to sustain the business, says Philip Harriman, a chartered financial consultant and partner at Lebel and Harriman LLP, Falmouth, Me. "If such key people were to pass away, the value of the stock could be significantly harmed. Also, the lender funding an ESOP may insist on key person life insurance to ensure a bank loan funding the sale will get repaid."

Life insurance, sources add, is increasingly used in seller-financed deals in which the owner receives a promissory note in exchange for the transfer of stock to the company. In the event the seller should die before the purchase price is paid, the policy death benefit can cover income or estate tax owed on the note and to provide for the deceased's family members.

"Whenever you have a company debt, you almost always want life insurance to cover that debt," says Rosen. "If I sell $5 million in stock to the ESOP, and take back a promissory note from the company, I'll want to be sure my family is protected in the event of my death. That's the first use of life insurance in these transactions: to cover the debt of the leveraged ESOP."