The Importance of a Buy-Sell Agreement

 

The importance of a Buy-Sell Agreement
 
Buy-Sell agreements are agreements by and between shareholders or partners of a privately held business that govern transfers of equity. Buy-Sell Agreements are critical to the ownership succession of an entity. In a closely-held business the ability to maintain the business after one stockholder dies depends on ownership in the hands of those who actually conduct the business and away from those who may hinder its success. This is accomplished by a buy-sell agreement that controls the disposition of equity interests of the business.
 
When a stockholder dies, the disposition of his stock depends upon key factors
  • Is the decedent a majority or minority stockholder?
  • Is retention or sale of stock desired?
  • Is there a market for the stock?
 
A minority interest in a corporation has little value to an owner who is not working in the business. Close corporations rarely pay dividends. Without an agreement the estate is in a poor bargaining position.
 
If the decedent was an equal owner, the decedent’s spouse or children may have a vote equal to the shareholder who is running the business. If the decedent was a majority owner will the minority stockholder be able to afford the buyout?
 
A Buy-Sell agreement will bring certainty and benefits for all parties.
 
  • Benefits to the deceased’s family
    • They receive a fair price for the stock
    • They are free from business worries
 
  • Benefits to the buyer of the business
    • Has control of the business and its future earning potential
 
  • Price and Terms
    • Established prior to the crisis
  
Generally, the two most popular types of Buy-Sell agreements used are a Stock-Redemption Plan or a Cross-Purchase Plan. Under the Stock-Redemption Plan the corporation (or partnership) buys the interest of the deceased business owner. This type of arrangement is often used when there are several owners. If life insurance is used to fund the agreement, the corporation will be the policy owner, beneficiary, and premium payer. 
 
Under the Cross-Purchase Plan each surviving owner agrees to buy the interest of the deceased business owner. This type of arrangement is often used when there are two owners. If Life insurance is used to fund this agreement, the shareholders will be the policy owners, beneficiaries, and premium payer. If the corporation pays the life insurance premiums, it must be treated as additional compensation to the shareholders.
 
Both Cross-Purchase and Stock-Redemptions agreements are often funded with life insurance. Under provisions of IRC Sec. 101(j), added by the Pension Protection Act of 2006, death proceeds from a life insurance policy owned by an employer on the life of an employee are generally includable in income, unless certain requirements are met.
 
If life insurance is used to fund the agreement, multiple policies will be needed. With a Stock-Redemption plan only one policy for each shareholder will be needed. In the case of a Cross-Purchase Buy-Sell, the plan may require many policies. The formula is number of shareholders times the number of shareholders – 1. For example, if there are 5 shareholders, you would need 20 life insurance policies, i.e., 5x (5-1)
 
The advantages of using life insurance to fund the agreement are:
  • The surviving stockholder will be guaranteed to have sufficient cash to purchase stock from the deceased’s spouse, heirs or estate.
  • It will reduce or eliminate the strain on future working capital in return for relatively small, predictable annual transfer of cash for the premium to an insurance company.
  • The surviving shareholder will get a full step-up in basis on the price paid for the stock by using the proceeds of the life insurance policy while only paying the smaller premium.
 
With a Stock Redemption plan, when one of the shareholders dies,  the surviving stockholders own a larger percentage of the outstanding shares, but their basis in the stock does not change, causing a higher capital gain at a later sale of the stock.
 
With a Cross-Purchase Buy-Sell agreement, the surviving owner who purchases the stock of the deceased owner’s spouse, heirs or estate will get a new basis in the acquired stock, which is used to measure taxable gain at a later sale of the stock.
 
Without having a Buy-Sell Agreement there is a strong possibility there will be conflicting interest and dissension. The reasons for this are:
 
      • Often, part of the business ends up in the hands of inactive heirs who can add little to the business, but want income equal to working shareholders. The result is an increased probability of business failure. 
 
      • A surviving stockholder doing his or her own job, and probably that of the deceased stockholder as well, would want as least the same salary as before, if not more, in recognition of the increased responsibilities. Also the surviving stockholder may want to reinvest profits back into the business rather than being paid out as dividends.
 
      • On the other hand, the heirs of a deceased stockholder would want the corporation to pay dividends and/or hire one or more family members at the highest possible salary. Typically, lots of income will be needed to maintain the current living standard and to pay the unexpectedly high debts, taxes, and expenses that accompany death.
 
A legal Buy-Sell Agreement is often the best solution to avoid conflict and dissension. The document, prepared by an attorney, is a legal instrument which requires the corporation (in the case of a stock redemption agreement) or the remaining stockholders (in the case of a cross-purchase agreement) to buy the stock of a deceased, retiring, or permanently disabled stockholder. It would require the estate of the stockholder to sell under a formula devised while both parties are alive and well.
 
Recapping the advantages of Buy-Sell Agreements:
  • Guarantees a buyer for an asset that probably will not pay dividends to one’s heirs.
  • Can establish a value for federal estate tax purposes that is binding on the IRS. See IRC Sec. 2703
  • Spells out the terms of payment and is easily funded with life insurance and disability insurance, if desirable.
  • Provides smooth transition of complete control and ownership to those who are going to keep the business going.
 
Setting up a Buy-Sell Agreement involves a considerable amount of time and thought, as well as teamwork and cooperation among all the members of your advisory team.