Estate Planning for Your Business: The Buy/Sell Agreement

A Buy/Sell Agreement is the legal cornerstone for the successful transition of a closely held business.  A formal Buy/Sell Agreement creates a market for each owner’s interest in a business in the event of his death, disability or retirement.  In the absence of such an agreement the deceased business owner’s heirs may become unwelcome or unwilling partners.  A properly drafted Buy/Sell Agreement can help ensure that heirs or retiring partners receive a fair market value for the business interest.

There are two basic types of Buy/Sell Agreements.  The first type is a Stock  Redemption or Entity Purchase Agreement.  In this scenario, the business itself agrees to purchase the shares of a deceased or withdrawing owner.  The second type is a Cross-Purchase Agreement.  In this arrangement, the owners agree to buy and sell each other’s respective interests in the business.

Many Buy/Sell Agreements need improvement.  Typically, such agreements are prepared either by business attorneys or estate planning attorneys.  At times, business attorneys neglect estate tax ramifications when establishing these arrangements.  On the other hand, estate planning attorneys do not always consider the economic and management issues which arise from retirement or disability.  A properly drafted agreement should carefully and comprehensively incorporate business and estate planning principles.

There are five basic ways to fund a business continuation agreement:

  1. cash flow
  2. sinking fund
  3. borrowing
  4. installment sales; and
  5.  life insurance

If a Buy/Sell Agreement is not funded, it has little value.

A Cross-Purchase Buy/Sell Agreement is an arrangement between shareholders to buy the other’s shares at death.  Each shareholder pays insurance premiums for a policy on the other.  Upon death or permanent disability, the insurance company pays policy proceeds to the surviving shareholder(s).  The surviving shareholder(s), in turn, purchase the deceased shareholder’s stock from his or her estate.

In this arrangement, the transferred shares receive a “step-up”  in basis for income tax purposes.  In short, the new basis equals the price paid for the shares.  Savings from capital gains should be realized if the shares are later sold at a higher price.  In addition, life insurance policies may be insulated from a company’s creditors.  The major obstacle in utilizing this format occurs if there are more than two or three shareholders.  Administratively, a Cross-Purchase Agreement requires a separate policy for each shareholder.

In the event of multiple owners, a company may wish to utilize a Trusteed Cross-Purchase Buy/Sell Agreement.  Under this arrangement, all policies would be owned by a trust, and only one policy per shareholder would be required to fund the Agreement.  An independent trustee would be the beneficiary of each policy.  Upon the death of a particular shareholder, the trustee would transfer the death benefit to the decedent’s estate in consideration of the decedent’s shares, in turn transferring the shares to the remaining shareholders at a “stepped-up” basis.  The major consideration in this case is to avoid the assessment of tax for a transfer for value to the surviving shareholders.

The alternative to a Cross-Purchase Agreement is a Stock Redemption Plan.  This plan establishes an agreement in which the company purchases the insurance on behalf of the shareholders.  Upon death, the company utilizes the proceeds to purchase shares from the deceased shareholder’s estate.  Administratively, this plan is easier in that fewer policies must be purchased.  However, certain disadvantages exist.  For example, the surviving shareholders’ interest will increase, but not the basis in the shares.

In all, a Buy/Sell Agreement should explore business viability and estate planning concepts.  The type of agreement employed should reflect the analysis of such concepts.

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