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. There are two basic types to consider, the Cross-Purchase Agreement and Stock Redemption.
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).
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. Typically, with this arrangement, the co-interest holders personally own life insurance policies on the lives of each of the other interest holders. This generally becomes too complex when dealing with a large number of owners. Funding can also be cumbersome, confusing, and potentially more expensive. These difficulties have led to the creation of other types of Cross-Purchase Agreements.
One example is a Trusteed Cross-Purchase Agreement involves the creation of either a revocable or irrevocable trust. The trustee would be responsible for handling all the paperwork, owning and maintaining the life insurance policies, and ensuring parties fulfill the terms of the buy-sell agreement. A Trusteed Cross Purchase Agreement can streamline the agreement and eliminate complexity and expense.
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.
Another option would be a Stock Redemption plan, wherein the business or corporation agrees to redeem the shares of stock of an interest holder at his or her retirement, death or disability. Again, the redemption is typically funded with a life insurance policy. This is another arrangement that works well when there are a large number of owners.
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.
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.
- The purchase of capital (life insurance).
- Borrowing the money.
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.
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.
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