Buy-Sell Agreements: What Are They And How Do They Work?

A buy-sell agreement is a formalized business continuation plan that is designed to provide for the orderly disposition or continuation of an individual’s ownership in a business.

A buy-sell agreement is a formalized business continuation plan that is designed to provide for the orderly disposition or continuation of an individual’s ownership in a business.

The buy-sell agreement allows the holder of a business interest to enter into an agreement that will provide for the future sale of that interest should death, disability or retirement occur. Under the terms of the buy-sell agreement, the specified buyer is legally obligated to purchase the interest, and the interest holder or his/her estate is legally obligated to sell the interest upon the occurrence of one or more specified events.

A properly structured business continuation agreement has many advantages. It can:

  • Control the value of the business for estate tax purposes and the estate taxes due on the assets.
  • Ensure the continuity or orderly disposition of the business.
  • Protect the surviving owners from gaining an undesirable co-owner (such as a member of the deceased interest holder’s family).
  • Convert the business interest into cash to provide financial security for the deceased interest holder’s family.
  • Ensure that cash is available to execute the agreement.
  • Assure the interest holder that there will be a buyer for the business.
  • Reassure business creditors by providing business continuity.

Once the decision is reached that a buy-sell arrangement is needed, then the owner(s) must determine which type of agreement is appropriate. There are two basic types to consider, the Cross-Purchase Agreement and Stock Redemption.

Cross Purchase Agreement

Under the Cross-Purchase Agreement, each interest holder agrees to buy the interests of the other owners under the terms of the agreement. A straightforward Cross-Purchase Agreement works well for a smaller business where there are fewer than four owners. In this type of arrangement, the co-interest holders personally own life insurance policies on the lives of each of the other interest holders. This arrangement generally becomes too complex when dealing with a large number of owners because it is difficult to calculate who buys what percentage of stock at the death of one of the owners. Funding can also be cumbersome, confusing and potentially more expensive due to the fact that multiple policies would be required on the lives of each of the current business owners. There are several variations on the straight Cross-Purchase Agreement designed to help overcome the drawbacks associated with a large number of owners.

A Trusteed Cross-Purchase Agreement involves the creation of either a revocable or irrevocable trust. Under this arrangement, the business owners would establish a trust with a third party (the trustee) who would be responsible for handling all the paperwork, owning and maintaining the life insurance policies, plus ensuring that the parties fulfill the terms of the buy-sell agreement. A Trusteed Cross Purchase Agreement can eliminate the need for multiple policies on the life of each interest holder and reduce the cost of funding the agreement.

Under a Partnership Among Shareholders, the life insurance policies used to fund the business continuation plan are transferred into a partnership. Many practitioners recommend this approach, but there may be some issues with the IRS and the Department of the Treasury to consider.

Following are some advantages of a Cross-Purchase Agreement:

  • The surviving interest holders receive a step-up in basis equal to the price they paid for the withdrawing or deceased owner’s shares.
  • Policy cash values are available to the owners, because they personally own the policies on each other’s lives.
  • The incorporated business does not have to own a life insurance policy to fund the agreement, thus avoiding any corporate alternative minimum tax on the death proceeds.
  • The agreement may avoid unintended shifting of control that can occur with redemption.

Stock Redemption

Under a Stock Redemption plan, the business or corporation agrees to redeem the shares of stock of an interest holder at his or her retirement, death or disability. To fund the redemption, the corporation acquires a life insurance policy on the stockholder and is both owner and beneficiary of that policy. This arrangement works well when there are a large number of owners because it is less complex.

Following are advantages of a Stock Redemption plan over a Cross-Purchase Agreement:

  • Only one insurance policy is in force per shareholder.
  • Policy cash values are available to the corporation.
  • The plan generally avoids transfer-for-value problems because a deceased or withdrawing stockholder has no ownership interest in policies that insure the remaining stockholders.
  • There is normally no direct taxation to the individual owners from the business-owned policies.
  • If there are large premium spreads because of face amounts, age or ratings, the cost differential is absorbed by the business, not the individuals.

Funding

Funding of the buy-sell/business continuation agreement is the single most important factor in the equation. Buy-sell agreements will not work unless funding arrangements have been made prior to the execution of the agreement. A buy-sell agreement may be funded through:

  • Cash flow generated by the business.
  • Establishing a sinking fund.
  • Borrowing the money.
  • The purchase of capital (life insurance).
  • Purchasing decedents or withdrawing owner’s shares on an installment sale basis.

All but one of the funding vehicles listed above have serious disadvantages with respect to timing, cost and impact on the business. Probably the best approach to funding a buy-sell agreement is through the use of life insurance. The use of life insurance offers the following advantages:

  • The funds will be available when needed for the purchase/redemption.
  • The death benefit proceeds can be income tax-free.
  • Annual cost of life insurance is usually 1 percent to 4 percent of the death benefit.
  • Cash values are allowed to grow tax-deferred.
  • Cash values are readily accessible.

There are other forms and variations of buy-sell agreements. Remember there are disadvantages and advantages to each, and all should be examined before decisions are made. You should consult with your attorney, financial planner or other professional advisor to determine which arrangement is best for your situation.

Reprinted with permission from The Family Business Report sponsored by the Goering Center at the University of Cincinnati College of Business Administration.