Business Contingency Planning: Buy-Sell Agreements

Sep 03, 2013 | by Franck Cushner, CFP®

Life has its unexpected events; but does your business plan for them?  A closely held business has a few options that can make the transition and transfer of ownership a bit smoother.  Following the death of an owner at a partnered-business, some questions should be answered in a drafted buy-sell agreement.  These questions may be:  Will the other partners fund a buyout of the deceased partner's interest?  What is the valuation of interest of the deceased owner for purposes of estate tax?  

In the case where a business owner dies, here are two types of arrangement plans.

Cross-Purchase Arrangement:
    In this arrangement, the surviving owners are personally obligated to purchase the deceased owner's interest.  We'll assume that the business had 3 owners, and has a worth of $3 million.  The funding needed for buying the shares of the deceased partner comes from insurance policies owned by each owner, which insures the lives' of the other two owners.  Respectively, each owner has a policy worth $1 million dollars.  In the event of the death of one of the company's partners, the insurance policy of the deceased owner would be received (tax-free) by the surviving owners.  This insurance benefit will be used for each living owner to purchase the shares of the deceased owner.  The main advantage of this agreement is that the value of the company remains unchanged, leaving the company free of AMT and AET tax issues.

Stock Redemption Arrangement:
    In a redemption style agreement, the business, itself, would buy out the shares owned by the deceased owner.  Again, we'll assume that the business has three owners, and is worth $3 million dollars.  This arrangement is also accompanied by an insurance policy.  However, this policy names the company as the beneficiary.  Each owner would have a policy in their name: $1 million for each owner, respectively.  Following the death of an owner, the benefit of the policy would be received by the company, and used to buy out the shares of the deceased owner.  Thus, the two remaining owners would now own 50% of the company, instead of the previous 33% ownership of each owner.  Consequently, the value of the company would rise after the benefit is received by the company, which, in turn, creates accumulated earnings issues for tax purposes.  

In order for the purchase price of the company to be set, the company's settings and shares must be valued.  This can be done through independent appraisals of the company.  

Your business has a few options to fund the buyout, in the event it's necessary.  First, a savings plan can be used to save the money needed for the buyout.  The next option is borrowing the money through a bank loan.  The disadvantage of the bank loans are that they accrue interest.  Finally, life insurance can be used to cover the cost of the buyout.  Having insurance is certainly the most cost-efficient method of funding the buyout.  Insurance is generally tax free, as well.

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