Business Continuation with Buy-Sell Agreements
A buy-sell agreement is an agreement between the owners of a business that defines the continuation of the business. The agreement states that the interest of anyone who passes away will be purchased by the surviving co-owners (or by the business) at a price that is agreed upon and stipulated in the agreement.
Why Consider a Buy-Sell Agreement?
Private shareholders of businesses often find buy-sell agreements an attractive option because they have a significant financial interest in the company and surviving family members would be able to conduct a fairly stress-free sale of the business should that be a possible action. Family members may also even be able to receive a sum of cash to use to help support them after the owner’s death.
In simple terms, a buy-sell agreement allows surviving owners of a business to purchase the shares from a deceased partner and not have to worry about bringing the heir(s) of a deceased partner into the ownership group.
The buy-sell agreement also provides a buyout strategy if the sole owner of a business wants to leave the business to an employee or group of employees rather than surviving family members. A buy-sell agreement will legally specify what will happen if an owner of a business dies, becomes disabled, or cannot perform his or her responsibilities associated with his or her ownership.
The Elements of a Buy-Sell Agreement
As a defined succession or continuation plan for your business, there can be numerous elements specified to protect the interest of the owners of the business. Although there are many elements to consider, there are some that are considered key elements and should be contained in all buy-sell agreements:
|Parties to the Agreement||For your buy-sell agreement (contract) to be valid, there must be at least two parties to the contract. Typically the parties to the contract are partners or owners of the business unless the agreement is made between a sole owner and his or her employee(s). The creator of the agreement must also identify whether any legal obstacles or licensing requirements could hinder the transfer of ownership.|
|Qualifying Events||The qualifying events that would trigger a buyout must be specified in the contract. Typical events would be death, disability, divorce, or retirement. It's important, however, to consider unusual events that could affect business such as breach of contract, malfeasance, or loss of reputation.|
|The Valuation Clause||You certainly can't have a buy-sell agreement without defining the value of the business. The value must be accurate and accommodate the business's growth over time. This can be done using an experienced business appraiser that should be knowledgable about your industry and have the ability to formulate an anticipated rate of growth rather than creating a new agreement every time there is a significant increase in the value of the business.|
|Funding the Buy-Sell Agreement||To be certain that each buyer has the financial ability to honor the payment terms in the contract, it makes financial sense to use life insurance as a funding vehicle rather than take the chance that each party to the contract will have the cash on hand to honor his or her share of the agreement.|
|Tax Consideration||Since buying or selling ownership of a business can be a taxable event, it's critical to get the input from a CPA or tax professional to minimize any possible tax liability resulting from the agreement being triggered.|
Types of Buy-Sell Agreements
There are two primary types of buy-sell agreements that are used for business continuation purposes and both can be funded with life insurance.
Entity Purchase Arrangement
With an entity-purchase agreement, the business will purchase an owner’s share of the business at an amount that has been defined in the business valuation when a triggering event happens.
If the business organized as a corporation, the agreement will be referred to as a stock redemption agreement. If the business is organized as a partnership, the agreement is then referred to as liquidation of interest.
If the comp ownership decides to use life and/or disability insurance to fund the agreement, the business will own the policy or policies and be listed as the beneficiary for each stakeholder and uses the death benefit to redeem the stakeholder who has died or become disabled. The business is the owner, payer, and beneficiary of the insurance policies.
If cash-value life insurance is used (whole life or universal life), the cash value that accumulates over time is considered an asset of the business and listed on the balance sheet.
The cross-purchase agreement is more complicated since each stakeholder is responsible for insuring the lives of the other stakeholders and would be the payer and beneficiary on each policy.
The death benefit for each policy would equal the individual’s share of the company’s value and upon the death of an owner would use the funds to purchase the shares from the deceased’s estate or heirs.
The cross-purchase plan is typically too cumbersome to implement when there are more than two or three stakeholders in a company. In this situation, the stakeholders could agree to implement a “trusteed” cross-purchase agreement where a trust is used to own one policy on each stakeholder and then represent the other stakeholders in the transaction.
When using the cross-purchase agreement that includes disability as a qualifying event, the same rules would apply as with life insurance. In any case, it’s critical that stakeholders consult with an attorney, CPA, or qualified insurance professional.
Funding a Buy-Sell Agreement with Life Insurance
One of the most popular ways of funding a buy-sell agreement is with life insurance in a cross-purchase buy-sell agreement. These agreements state very clearly what would happen in the event that one of the owners dies or becomes disabled. The surviving owners agree to purchase that owner’s interests in the business. For each owner, a life insurance policy is purchased and has a death benefit equal to the current value of each owner’s share of the business. It should be noted that in order to take into account the potential future increase of value, benefits greater than the current business value can be purchased as well.
The Details of the Agreement
Buy-Sell agreements can be funded with either permanent (cash-value) or term life insurance. The difference between the two types of policies is that the cash value of a permanent policy can be used for non-death related buyouts. Both types will pay the death benefit, however.
The beneficiary can use the benefit received to pay the estate of the deceased owner an amount that is equal to the value of his or her business interest. In the event that additional life insurance was purchased as key-person insurance, that money could be used by the business to offset any income loss resulting from the owner’s death.
Advantages of Funding Buy-Sell Agreements with Life Insurance
Life insurance proceeds are normally paid within a very short amount of time after one’s death, so the buy-sell transaction can be quickly settled. Additionally, life insurance proceeds are usually income tax-free, and there are different types of agreements to choose from in addition to the aforementioned cross-purchase agreement. In an entity purchase agreement, the business itself buys separate policies on the lives of each co-owner, pays the premiums, and is the owner and beneficiary. A hybrid policy, often also called a “wait and see” policy, allows features from both the cross-purchase and the entity purchase models.
Tax Considerations with a Buy-Sell Agreement
While tax concerns should be addressed by your CPA, some basic considerations can be addressed here:
• All insurance premiums used to finance a buy-sell agreement are not tax-deductible.
• The death benefit is delivered tax-free irrespective of who acquired and owns the insurance policy unless the death benefit is payable to certain corporations. The death benefit that is received by the C corp may result in an alternative minimum tax for the corporation. In order for the death benefit to be received tax-free, there can be no exchange for valuable consideration.
• insurance premiums paid by a company in which the shareowner is the named insured are not regarded as taxable income to the insured person.
• There is no gift tax responsibility upon the execution of a buy-sell agreement.
• When implementing a cross-purchase agreement, one should be cautious of the transfer for value rule.
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