Buy / Sell Agreements For Business
Own a business? Have a will for your business? Sole proprietorships, partnerships and small closed corporations all need to consider what happens if the owner or one of the partners or shareholders dies or becomes disabled. Who will purchase the company or the deceased partner’s or shareholder’s interest? What is a fair price? When will the sale be made? Will the deceased owner’s/partner’s/shareholder’s families be given a fair shake and taken care of? These are real questions every small business should deal with before the event occurs.The business itself may also suffer form a supplier’s or creditor’s perception of the value of the deceased person to the success of the business. Key employees may consider the deceased’s death as a reason to move elsewhere. There needs to be continuity and a smooth transition in the business when tragic events such as deaths or disabilities occur. The buy-sell agreement is important to resolve a lot of problems dealing with employees, creditors, suppliers and the deceased person’s family. Importantly, where will the funds come from to provide continuity and a smooth transition? Everyone is going to die and sometimes it happens totally unexpectedly and at a much younger age when expected. There are no dying rules specific to owners, partners and shareholders. Stuff happens! A buy-out sell agreement is, essentially, the will for the business and it eliminates a lot of difficulties and heartaches when a key person dies. A plan needs to be in place and a method of funding that plan must also be available.
There are several options for business owners to fund a buy-sell agreement:
- They can wait and see – “I’ll worry about that if and when it happens.” A sole proprietor can say, “I’ll be dead, so no reason for me to worry about it.” Sure! If it is a partnership, the partnership dissolves automatically and, “My partner will do the right thing.” Is that what you want? You can use your personal funds to buy-out your partner’s stock. But what if it comes at a bad time? Your personal stock portfolio is down, you’ve got two children in college, and you’ve had to take less income form the business lately because business has been in a slump. Maybe, after a lengthy probate the corporation can buy the stock and place it into treasury stock, if funds are available.
- But where does this leave the family of the deceased? Would you leave it up to your partners to do the right thing for your family no matter what the personal cost would be to the partner?
- They can borrow funds – obviously, borrowing funds is not an option to a dead sole proprietor. Could a key employee put together the money to purchase the company? Can the surviving partner(s) borrow enough to purchase the assets of the deceased partner? Maybe they can take out a second mortgage on the house? Maybe the lost one is the one depended upon by bankers and suppliers. Maybe the repayment and interest is simply too burdensome.
- They can set-up a savings account within the company in anticipation of an event like this happening but, again, if you are a corporation there may be accumulated earnings tax problems and if you are not a corporation, it may be difficult to maintain a savings account or the death may occur prematurely before enough funds are available.
- They can buy life insurance.
Let’s look at this from a sole proprietor’s, a partnership’s and a corporation’s perspective.
Unless a sole proprietor (let’s call the person and “owner”) has a family member or a close relative to turn the business over to and feels comfortable the owner’s desires for his/her family members will be served, the options are limited. The business can be closed, it can be sold to an outsider, although small businesses are sometimes difficult to sell, or, if the owner wants his ‘baby’ to continue, it can be sold to one or more competent and faithful employees. The buy-sell agreement to a trusted employee becomes a two-step plan:
- An agreement is prepared which sets forth the employee’s obligation to buy, the price the employee(s) will pay for the business and the method of payment
- The employee takes out a life insurance policy on the owner. The employee is the owner of the policy, the person who pays the premiums and the beneficiary.
If the owner dies, the death benefits of the insurance policy would be used to buy the business from the owner’s estate.
Partnerships are automatically dissolved with the death of one partner; therefore, a buy-sell agreement is very important. In this case, a buy-sell agreement would sell the deceased’s interest in the company to the surviving partner(s) at an agreed to price. For partnerships there are two different plans:
Entity Plan – in this plan partners enter into an agreement with the partnership who owns, pays the premium payments and is the beneficiary of the policies. When a partner dies, his/her interest is purchased from his/her estate by the partnership at the buy-sell agreement price and the interest is then divided among the surviving partners in proportion to their own interest.
In this case, the $600,000 business discussed above would purchase a $200,000 policy for each of the three partners. If one of the partners dies, the business pays the deceased partner’s share from the death benefit of the policy and distributes those shares equally to the two remaining partners. The remaining partners, in this case, would then each own 50% of the business.
Because of origination funding, buy-ins, etc., not all partnerships are owned equally by the partners. In those cases, both the insurance policy’s amounts and the benefits distributions would be made on the basis of each partner’s proportionate share in the business. Additionally, none of the premium payments in the above plans are tax deductible; however, the benefits are tax-free.
Unlike a partnership, a closed corporation (i.e. a small number of shareholders who run the business) does not cease to exist with the death of one of its shareholders. For closed corporations, there are also two different plans:
- Cross-purchase plan – each stockholder owns, pays for and is the beneficiary of life insurance on the other stockholders in amounts equivalent to his or her share of the purchase price. The corporation is not a party to the agreement. The surviving stockholders purchase the interest of the deceased stockholder as individuals from the estate of the deceased stockholder. This plan is like the cross-purchase plan described in the partnership section above. Obviously, the more shareholders the more difficult this plan becomes.
- Stock redemption plan – the corporation, rather than the stockholders, purchases the insurance policy, pays the insurance premiums and is the beneficiary on the lives of each shareholder. The amount of insurance on each stockholder is equal to the proportionate share of the purchase price. Upon the death of one of the stockholders, the death benefits are paid to the corporation who then buys the deceased’s stock from the deceased’s estate. Premiums are not taxed deductible but the proceeds are received income tax free.
Advantages of Buy-Sell Agreements
- Can guarantee a buyer for an asset which may not pay regular income to one’s heirs.
- Under certain circumstances, can establish a value for federal estate purposes which is binding on the IRS.
- Can spell out the terms of payment and is easily funded by life insurance and disability insurance, if desirable.
- Can provide a smooth transition of complete control and ownership to those who are going to keep the business going.
Methods of Funding a Buy-Sell Agreement
Personal Funds of Buyers
Most successful business people do not keep large sums of liquid assets on hand. Their money is working in their business.
Sinking Fund in the Business
Such a fund will be inadequate if death is premature and the time of need is uncertain. A corporation may develop an accumulated earnings tax problem.
Loss of a key person may impair the credit-worthiness of the business and other partners and shareholders. Interest costs may be excessive and interest expense may not be deductible.
IInstallment Payments to Heirs by Buyer
The business may fail and the payments stop. The principal and interest payments may be too burdensome.
Life Insurance Owned by the Buyer
There may be several key advantages to life insurance in funding a buy-sell agreement:
- Complete financing guaranteed from the beginning.
- Death proceeds are generally free from Federal income tax.
- Cash values can be used for a buyout due to retirement or disability
- It may be the most economical method – discounted dollars.
- Credit position is strengthened.