Buy/Sell Agreements

Many business owners become so entangled with the day-to-day operations of their company, they forget the importance of how to protect their most valuable asset —the business itself. If one of your business partners dies or becomes disabled, where would you get the funds to purchase their share of the company? What if an outside owner who had a different vision from the majority purchases these shares?

Buy-Sell Agreement

A buy-sell agreement is a contract that outlines what will happen to specific business interests at retirement, death, or other triggering events. When a buy-sell agreement is funded with life insurance, a policy owner (usually a partner or co-owner of the business) uses the policy proceeds to buy available business interest at death or retirement. At retirement, the cash value of the life insurance policy may provide a down payment to help fund the buy-out of shares of a business.

Advantages

A well-constructed buy-sell agreement anticipates how the value of a business may change over time. It may also provide for appropriate adjustments in the amount of the buy-out expense. A properly designed buy-sell agreement can:

Cross Purchase

In a cross-purchase agreement, the business owners agree amongst themselves to collectively purchase the interest of any owner upon death. Purchasing life insurance policies on one another to fund the buy-out, each business owner buys a life insurance policy on all the other owners. At death, the surviving owners receive the policy proceeds and then purchase a pro-rata share of the deceased owner’s interest in the company.

Entity Purchase

With an entity purchase or stock redemption arrangement, the business will agree with each owner to purchase a deceased owner’s share of business interest. To accomplish this, the business buys a life insurance policy on each owner’s life (in an amount equal to his or her respective interest in the business). The policy proceeds are used to acquire stock from the deceased owner’s estate when a triggering event (i.e., death, disability, retirement) occurs.

Trusteed Cross-Purchase

When a cross-purchase buy/sell arrangement is desired, but the number of owners and the number of policies required to fund the arrangement makes this too complex, a trusteed cross-purchase agreement could be the solution. This arrangement is sometimes known as an “escrowed” or “custodian” buy/sell.

In a trusteed cross-purchase arrangement, a trustee or escrow agent holds each owner’s stock certificates and owns one life insurance policy on each owner. At the death of an owner, the trustee collects the policy proceeds and pays the deceased owner’s estate in exchange for the business interest owned. The trustee then credits each surviving shareholder’s account”, with the appropriate pro-rata ownership of the purchased shares. By agreement, the deceased owner’s escrowed interest in the policy insures anything reallocated to the surviving owners.

Wait and See Purchase

Determining whether a cross-purchase buy/sell arrangement or a stock redemption plan is more suitable may be difficult to determine at the time the plan is adopted. A wait-and-see agreement lets the business owner(s) wait until the first death or another triggering event to occur before deciding whether the business or the owner(s) should purchase the business interest. This flexibility is useful because the best results often cannot be determined until a triggering event occurs. The wait-and-see agreement allows the purchaser to be the entity, the owners, or both. With the typical wait-and-see agreement, the business has the first option to purchase the stock at the price or formula set in the agreement. If the business fails to exercise its option, the surviving business owner(s) have a second option to purchase the stock. Finally, if the business owners fail to purchase the stock or only purchase a portion of it, then the entity is required to purchase the remainder. A wait-and-see arrangement adds flexibility because if a cross-purchase plan is more advantageous than a stock redemption, the business will not exercise its first option to buy the stock. On the other hand, if a stock redemption plan would be the most advantageous, and the insurance policies are owned by and payable to the shareholders, the surviving shareholders may decide to lend the proceeds to the entity after a death occurs. When the entity pays back the loan, it will not be considered income to the owners, except for any interest that is paid on the loan.

Buy/Sell Agreements