According to the Small Business Administration article Transferring Management in the Family-Owned Business, ‘…At any given time, 40 % of U. S. businesses are facing the transfer of ownership issue. Founders are trying to decide what to do with their businesses…’ And this is coupled with the fact that about 50,000 Americans are reaching retirement age every week;[i] and that in addition to needing retirement income, the cost of long-term care for two spouses could be in the hundreds of thousands. For many business owners, family members, partners, and even key employees, the buy-sell agreement offers some solutions.
Business and Family Strategic Planning is the first logical step to preparing for future events and achieving desired goals. If you are faced with transferring business assets, shares, or interest; or if you are in a partnership or share owner-ship in an LLC or Closely-held corporation, you should research the buy-sell agreement. It is often difficult to deal with letting go of something that you had an integral part of creating and building; however, if you do not address the issue of transferring your assets while you are able, then someone else will do so when you are no longer able to make the choices.
- THE BUY-SELL AGREEMENT:
A Buy-Sell Agreement is a contract that provides for the transference of your business interest or for your purchase of another’s share in the business. Buy-Sell arrangements are also known as business continuation agreements and business buyout agreements. These contracts can protect the company’s continuity, as well as fulfill the departing (as decorously as possible – I mean ‘dead’ or ‘alive’) owner’s exit strategy legally. The buy-sell agreement consists of at least two parties, whereas upon a ‘triggering event,’ one party sells a defined portion of their business interest to another party. Typical and legal ‘triggering events’ include the death, disability, divorce, incapacity, or retirement of at least one of the co-owners.
A standard Buy-Sell Agreement will include the date, defined the parties, and specify the terms of the contract including: the precise ‘event(s)’ which will ‘trigger’ the agreement, the number or percentage of shares to be transferred, the persons who will receive that interest, and the persons who will receive benefits for that interest and the terms and descriptions of those benefits. There are several different types of buy-sell agreements, including: entity purchase; cross purchase; one-way buy-out; and wait and see arrangements.
- PURPOSES: A business owner is concerned about:
- How the death of a co-owner might affect the company’s operation.
- A partner’s spouse/children taking control of the company.
- How a partner’s disability could affect the company.
- The continuation of their company.
- How much money their family will receive from the sell of their business upon their death, disability, or retirement.
- A succession strategy; and/or who will take over their company.
- TYPES OF BUY-SELL AGREEMENTS:
Trusteed Cross Purchase
Wait and See
There are two critical steps to a sound buy-sell agreement: drafting the agreement, and funding the agreement. The majority of these contracts are Entity Purchase or Cross Purchase agreements. Under Entity Purchase or Stock Redemption plans, the company purchases the owner’s interest at their death or qualifying event. With these contracts the plan costs are equalized among partners because the business is funding the arrangement. And any cash values or sinking funds are assets of the business. However, the fund or life insurance policy then becomes subject to the claims of the business’ creditors, life insurance premiums are not income tax deductible and the death benefit is not tax-free. Additionally, life insurance proceeds could increase the value of the company and estate taxes.
Under Cross Purchase plans the individual owners or partners and/or key employee(s) fund the agreement; typically each party will own a life insurance contract on each of the other owners. Each surviving owner and/or key employee will pay pro rata proceeds to the deceased owner’s estate or beneficiaries; in turn the estate will give over the deceased owner’s pre-determined share. Generally, life insurance death benefits will be received income tax free; and the policies are not subject to creditors. The main disadvantage to these plans is that they are funded with after tax dollars, and are not deductible. However, the individuals own their interest in cash valued policies when used; and normally there are little or no capital gains on the sale of the deceased’s assets due to the ‘step-up’ rule.
A Trusteed Cross Purchase is used when the company has too many owners to justify a typical cross purchase arrangement. And Wait And See plans are setup to allow the business to ‘wait’ until the first owners’ death to ‘see’ whether the business, remaining owners, or both will purchase the deceased share.
Buy-sell arrangements can be funded by a sinking fund or side fund of the business; however, if a co-owner dies before all the funds have been accumulated, then the business or contract may be negatively affected. Buy-sell plans are often funded with life insurance to solve that problem. Sometimes they are funded with split-dollar life insurance arrangements.
Nevertheless, when funding a buy-sell agreement, the owners should consider using permanent life insurance for a portion of the needed coverage. Although, term life insurance and first-to-die plans are less expensive, because first-to-die plans can complicate succession and estate issues, and term plans will end or become costly, supplementing the future proceeds with cash value permanent life insurance offers the following advantages: available premium loans, reimbursed premiums, the ability to stop paying premiums, and lifetime coverage. If you are considering a buy-sell agreement, you should consult the appropriate legal, financial, and tax advisors.
[i] The Wealth Channel Magazine, Spring 2012, back cover; The American College.