Buy-sell agreements are a critical, yet often overlooked, succession planning tool for closely held business owners. They provide a source of liquidity to exiting owners and their families and help ensure the continuity of the business by retaining control in the hands of the remaining owners.

Co-owners of successful businesses learn to work together, collaborate and capitalize on their skills and contributions in order to grow their business and ensure its success. In doing so, their interests in the business become aligned. But what happens when the unforeseen occurs and one owner’s interest needs to be purchased or redeemed? Many business owners fail to properly plan for a potential breakdown in the team that built the business.

Death, disability, bankruptcy and divorce all pose a threat to the continued success of a closely held business. Each of these events can result in the need to quickly liquidate an individual owner’s share of a closely held business or risk that share ending up in the hands of an outside third party – or worse, the need to sell the business in order to cover the estate tax liability of a deceased owner. A carefully drafted and structured buy-sell agreement can help protect a business and its remaining owners if one of these unexpected events occurs.

Buy-sell agreements are particularly important for family businesses. Many families engage in estate planning for their descendants but do not think through the logistics of how the business will be properly transitioned if some family members are involved in the company and others are not. A buy-sell agreement can help families avoid conflict by providing liquidity to certain family members while retaining control of the business in the hands of the appropriate individuals.

There are two primary types of buy-sell agreements: redemption agreements and cross-purchase agreements. Both have unique features, advantages and disadvantages.

Redemption Agreements

Redemption agreements are contracts between business owners and the business entity itself. Under a typical redemption agreement, upon the occurrence of a triggering event (often defined as death, disability, divorce, bankruptcy or retirement), the owner agrees to sell, or offer to sell, his or her interest back to the company. The company is obligated to purchase or redeem the shares at a price determined by the terms of the agreement. The terms of a redemption agreement, including what constitutes a triggering event and how an owner’s interest is valued upon redemption, can vary widely.

An advantage of a redemption agreement is that the costs associated with funding the agreement are borne by the company rather than the individual owners personally. A redemption agreement is typically funded with life insurance and/or disability insurance on each of the owners, as discussed further later in this article. If the company has multiple owners, a redemption agreement only requires one policy per owner, provided the policy is sufficient to satisfy the buyout provisions. Annual insurance premiums must be paid by the company. If a company has owners with varying ownership percentages, each owner’s share can be required to bear the cost of his or her percentage of the premium.

There are also disadvantages to redemption agreements. While life insurance proceeds are typically income tax-free to the recipient, C corporations can be subject to alternative minimum tax (AMT) liability in certain circumstances. S corporations, partnerships and LLCs are not typically subject to AMT.

An additional disadvantage of a redemption agreement is that the remaining owners of most business entities do not receive a step-up in basis on the shares acquired from the departing owner because the business, rather than the individual owners, redeemed the shares. This means that the remaining owners may face significant capital gains taxes upon later disposition of those shares.

Cross-Purchase Agreements

In contrast to redemption agreements, cross-purchase agreements are contracts between the individual owners of a closely held corporation. In a typical cross-purchase agreement, each owner agrees to purchase the interests or shares of a deceased or departing owner at the price and terms agreed upon in the contract.

Like redemption agreements, cross-purchase agreements are generally funded with life insurance or disability insurance on each owner. Because this requires each owner to buy a separate policy on each other owner, cross-purchase agreements are often most appropriate for businesses with relatively few owners. In the case of a business with many owners, the requirement to purchase numerous policies may add unwanted costs and complexity. However, it is possible for some owners to participate in a cross-purchase agreement while others do not.

Insurance proceeds are not subject to income tax when paid to an owner, and the proceeds are immediately available to purchase the interests of the departing owner. Because each owner buys the shares directly from another owner or his or her estate, the purchasing owner receives a basis step-up to the purchase price of the shares. This can be a significant advantage of a cross-purchase agreement over a redemption agreement.

Because cross-purchase agreements are typically funded by life insurance policies owned by the individual owners, the policies and proceeds are not subject to claims by the business entity’s creditors. However, they can be subject to claims by the policy owner’s creditors. For this reason, some owners choose to own life insurance on other owners through a life insurance trust, rather than individually. While a complete discussion of life insurance trusts is beyond the scope of this article, such a structure would provide creditor protection for the policy.

A potential disadvantage of cross-purchase agreements is the burden placed on each individual owner to pay the costs of life insurance premiums on the other owners. Not only can this strain the cash flow of the individual owners, but it can force younger, healthier owners to shoulder significantly higher premium costs than older, less healthy owners because the health and age of the insured will determine the cost of the premiums.

Funding and Valuation

Funding

A buy-sell agreement can be funded through cash in the business or through each owner’s personal funds, but most are funded with some form of life insurance, disability insurance or both. If business owners intend to exit or sell the business within a certain period of time, they could purchase term life insurance, which is usually significantly less expensive than permanent or whole life insurance. If there is no plan to sell a business, and the owners’ goal is to ensure that the business will continue after one or more of their deaths, permanent insurance will likely be a better option. One of the benefits of permanent insurance is that a policy owner can often take a tax-free loan against the cash value of the policy. This can provide liquidity in the case of divorce or bankruptcy, where the exiting owner is still alive and well.

Some business owners use a hybrid buy-sell agreement to provide flexibility around the funding of the agreement, particularly if one or more owners are uninsurable due to age or health. A hybrid buy-sell agreement may offer the business entity the right of first refusal to purchase an exiting owner’s shares upon the occurrence of a triggering event. If the business declines to purchase the shares, or a portion thereof, the remaining owners may purchase them.

Valuation

The terms of a buy-sell agreement dictate how an owner’s share will be valued upon the occurrence of a triggering event. Owners should work carefully with their attorney to ensure that the valuation method is appropriate for the particular business and the industry. Some buy-sell agreements specify a fixed price to be updated periodically. Fixed prices can be problematic because owners often neglect to update them, and they can become stale quickly. If a fixed price approach is used, business owners must be diligent about updating the price on a regular basis.

Other agreements tie the value of an owner’s shares to the face value of the life insurance or disability insurance policy. This can also be problematic because the face value of the insurance policy is unlikely to reflect fair market value of the shares at the time of a triggering event. This can leave a deceased owner’s family with insufficient assets.

Finally, many buy-sell agreements provide that the value of an owner’s interest will be determined by an independent appraiser at the time of the triggering event. This can be the best approach to ensure that the exiting owner or his or her family receives true fair market value for the shares. If an appraiser is to be used, the buy-sell agreement should specify how the appraiser will be selected in order to ensure fairness to all parties.

Conclusion

Amid the day-to-day rush of running a successful private business, many owners do not stop to consider how the business would survive if they were to die or become disabled or how their families would pay the bills, often including a hefty estate tax bill, if they were left with only illiquid business interests and no market for those interests. Buy-sell agreements are just one element of comprehensive business succession planning, but they can be a key tool in providing necessary liquidity to exiting owners and their families and ensuring that the business they worked so hard to grow and build will continue after they are gone.