A buy-sell agreement protects family business co-owners in the event one of those owners suddenly becomes incapacitated or, in due time, decides to leave the company. It restricts each shareholder, partner or owner of a business from unilaterally transferring an ownership interest to anyone outside the group. It also ensures there will be a willing buyer for each co-owner's interest when he or she retires, dies, becomes disabled or another "triggering event" occurs.
Obviously, business owners need sources of money to finance the buyouts of withdrawing co-owners when triggering events occur under a buy-sell agreement. The death of a co-owner is the most common and catastrophic event. For this reason, life insurance policies covering the lives of the co-owners generally form the financial backbone of a buy-sell agreement.
Here's an example of a simple case: A "cross-purchase" agreement is set up between two co-owners, with each person buying a life insurance policy on the other. When one co-owner dies, the surviving owner collects the life insurance death benefit proceeds and uses the cash to buy out the deceased co-owner's interest from his or her estate, surviving spouse or other heirs.
For tax purposes, cross-purchase arrangements are extremely beneficial. The life insurance proceeds are free of federal income tax as long as the surviving co-owner was the original purchaser of the policy on the deceased co-owner. If there are more than two co-owners, things get a bit more complicated because each co-owner must buy policies on all the other co-owners.
Warning: You shouldn't swap an existing life insurance policy on your own life for another co-owner's policy. Also, a co-owner shouldn't be designated as the new beneficiary of an existing policy on a business owner's life. If these things occur, it can turn the life insurance death benefit proceeds from 100% tax-free payment into 100% taxable under the "transfer for value rule." That could be a financial disaster!
If existing life insurance policies must be used to fund a buy-sell deal -- for example, because one or more of the co-owners are now uninsurable -- there are several ways to avoid the "transfer for value" problem. For instance, existing policies might be able to be transferred into a partnership owned by the co-owners. When one co-owner dies, the partnership uses the life insurance death benefit proceeds to buy out the deceased co-owner's shares and then distributes them tax-free to the remaining co-owners.
When the business entity itself buys policies on the lives of the co-owners and then uses the death benefit proceeds to buy out deceased co-owners, it's considered a "redemption agreement." Regardless of whether the entity purchases new policies or the co-owners transfer existing policies on their own lives to the entity, there's generally no "transfer for value" problem. In other words, the death benefit proceeds will be free of federal income tax.
Disability income insurance on the co-owners can be used to help fund buyouts that are triggered by co-owners becoming disabled. Payouts under disability policies are generally tax-free.
A buy-sell agreement should probably specify that any buyout that isn't covered with life insurance death benefit proceeds will be made under a multiyear installment payment arrangement. This gives the remaining co-owners some breathing room to come up with the cash needed to complete the buyout.
For the typical business owner, his or her share of the company represents a big chunk of estate value. Unfortunately, without a buy-sell agreement, this creates two large problems:
The good news: A buy-sell agreement can solve both problems. Most important, the agreement ensures a business ownership interest can be sold under financial terms that the co-owners have already approved. The potential liquidity problem of an estate is thereby solved.
In addition, the price set by a properly drafted buy-sell agreement also establishes the value of a business ownership interest for estate tax purposes. Heirs will avoid expensive, time-consuming and distracting hassles with the IRS.
Of course, the price must be realistic or the IRS can completely disregard the buy-sell agreement's valuation. The worst-case scenario occurs when the agreement sets an unrealistically low price that allows someone outside the family to buy the share of the business for less than it's actually worth. The heirs lose out. To add insult to injury, the IRS still has the right to come in and assess estate tax on the higher price that should have been charged but wasn't. So the heirs can lose out again.
The solution is to establish a solid buy-sell agreement that will withstand IRS scrutiny. For this, you need both valuation and tax advice from professionals experienced in these types of transactions. Contact your advisor if you want to learn more about setting up a buy-sell agreement for your family business.
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