Buy-Sell Agreements are Essential Business Planning Tools
Few business owners ever imagine being in business with their partner’s spouse or children; but that is the possible nightmare they face when they don’t have a proper, insurance-funded business transfer plan in place. Short of a funded business continuation plan, business partners or shareholders risk the dissolution of their company if they are unable to “buy out” the interests of a deceased partner’s family. For any business with multiple owners or partners, one of the most critical planning issues is preparing for business continuation in the event of the death of one of the owners or partners.
At the core of a business continuation plan is the buy-sell agreement, a legal document that dictates when, how and to whom the shares of a business will be legally transferred. For the buy-sell agreement to be effective, however, it must be funded, meaning, when death occurs, there must be capital in place to effectively buy-out the family or estate of the deceased partner. Life insurance has been the preferred method of funding agreements because, for a small investment, it can guarantee the funding of the agreed upon purchase price at the time it’s needed.
The main questions for business owners revolves around which type of buy-sell agreement is appropriate and the type of life insurance arrangement which will facilitate the business continuation plan most efficiently.
For small businesses with multiple owners, two of the more commonly used agreements are:
- Cross purchase
- Stock purchase (entity plan)
Cross purchase agreement
Appropriate for smaller businesses with three or fewer owners – generally used in partnerships.
- The agreement is between each owner who agrees to purchase the interest of the other owners at a specified price.
- Each owner owns a life insurance policy on the lives of the other owners and is the beneficiary of the policy.
- Under Section 162, the business can bonus the owners for the amount of premiums to be paid. The bonus compensation is tax deductible to the business and taxable to the owners.
- Upon the death of an owner, the proceeds are paid to the surviving owners which are then used to purchase the deceased owner’s interest from his or estate.
- The surviving owners receive a 100 percent increase in the cost basis of the interests purchased.
- To reduce the number of insurance policies in situations where there are multiple owners, a “trusteed” buy-sell agreement, administered by a professional trustee could be a viable alternative to a cross purchase.
Stock redemption (entity plan) agreement
Appropriate for business entities formed as a C Corp, S Corp, or LLC.
- The entity agrees to purchase the shares of each owner upon his or her death.
- The entity purchases and pays the premiums for life insurance policies on the lives of each owner. The entity is also the beneficiary of the policies.
- The premiums are not a deductible business expense (IRC Section 264).
- The entity uses the proceeds of the life insurance to buy back the shares from the deceased’ owner’s estate.
- Depending on the legal form of business, the surviving owners may or may not receive an increased cost basis of shares purchased. C Corp owners receive no increase; S Corp owners may receive 100 percent increase under certain conditions; and LLC owners will receive a cost basis increase proportionate to their share of the ownership.
Buy-sell agreements are complex legal documents and should be drafted by attorneys specializing in business transfer law. There are also tax implications which should be considered with qualified tax professionals for the business, the owners and their estates. However, business owners must recognize that a funded buy-sell agreement can be the most important document they’ll ever sign.