A business owner has many responsibilities. One responsibility in particular is planning ahead for retirement, disability, and death.
When a business owner retires, what happens to the business? If a business owner gets disabled and can’t work, what happens to the business? If a business owner dies unexpectedly, what happens to the business?
Having a buy-sell agreement in place is one way a business owner can protect the future of the business, their partners, employees, and family.
What is a buy-sell agreement?
A buy-sell agreement is a legally binding contract between an owner of a business and whoever plans to buy the owner’s share of the business if he or she dies, or are otherwise unable to continue in the business.
These parties get together and agree on a fair purchase price and the terms of the contract. The agreement also establishes a value for estate tax purposes, which helps avoid estate settlement delays and IRS challenges.
Life insurance is often used in conjunction with buy-sell agreements. It’s a cost-efficient and effective way of ensuring that the person or entity with plans to purchase the business interest has the funds to do so.
Who is involved in a buy-sell agreement?
For simplicity, we’ll focus on a buy-sell agreement that is triggered by the death of a business owner.
There are three parties involved with a buy-sell agreement. You have the business owner, the person or entity agreeing to buy the owner’s interest in the business (this is often a co-owner), and the business owner’s heirs.
The Goals of Those Involved
The surviving business owners want to be able to keep running the business without interruptions or interference from the deceased owner’s heirs. They do not want any third parties coming in and taking over the business they’ve dedicated many years to.
Surviving business owners also want to be able to purchase the deceased owner’s share of the business quickly and at a fair price. They also want to preserve the loyalty and support of all the employees, customers, and creditors during this difficult time.
The deceased owner’s heirs want ongoing financial security after the loss of their loved one. They either want to retain their rightful share of the business or receive a fair price for their business interests. And they want a prompt settlement of their loved one’s estate.
Business owners want to make sure that their business and family are both taken care of should they die unexpectedly. They do not want there to be any conflict or litigation between the surviving business owners and their loved ones.
Business owners want to make sure that their business and family are both taken care of should they die unexpectedly. A buy-sell can help.
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What are the different types of buy-sell agreements?
There are three main types of buy-sell agreements:
- One-Way Buy-Sell Agreements
- Cross-Purchase Buy-Sell Agreements
- Entity-Purchase Buy-Sell Agreements
One-Way Buy-Sell Agreements
A one-way buy-sell agreement occurs when there is a sole owner of a business. There are no co-owners to naturally take over if the owner dies.
Many sole-owner businesses don’t outlast their owners due to a lack of succession planning. A one-way buy-sell agreement can help ensure the business’s future success.
How does a one-way buy-sell agreement work?
In a one-way buy-sell agreement, the sole owner commits to sell, and the purchaser commits to buy the business interest if a specific event occurs. This event is typically the owner’s death. The purchaser, ideally, is one of the business’s employees.
The purchase price is pre-determined and defined in the agreement. The price is either determined by a fixed price, which should be re-evaluated from time to time, or a formula specified in the agreement.
The purchaser buys a life insurance policy on the business owner’s life in the amount equal to the purchase price. Upon the business owner’s death, the purchaser buys the owner’s share from the estate.
If the business owner ever wants to sell the business during his or her lifetime, the purchaser named in the buy-sell agreement has a “right of first refusal”. This means the business owner must first offer to sell the business to the named purchaser prior to attempting to sell it to a third-party. Only after the named purchaser declines the offer can the owner pursue a third-party sale.
Cross-Purchase Buy-Sell Agreements
A cross-purchase buy-sell agreement is a contract between business owners in which all owners commit to purchasing the business interest of another owner if a certain event occurs, typically death. This type of buy-sell works well for businesses with two to three owners who are all relatively close in age.
How does a cross-purchase buy-sell agreement work?
With a cross-purchase buy-sell agreement, each business owner agrees to buy a portion of a deceased owner’s business interest. To fund this, each owner buys a life insurance policy on the life of every other owner. The coverage amount of each policy in total should equal the total purchase price for that owner’s share of the business.
John, Sue, and Joe own equal shares in a business valued at $3,000,000. Therefore, each of their shares is worth $1,000,000.
John purchases a $500,000 life insurance policy on Sue and a $500,000 life insurance policy on Joe.
Sue purchases a $500,000 life insurance policy on John and a $500,000 life insurance policy on Joe.
Joe purchases a $500,000 life insurance policy on John and a $500,000 life insurance policy on Sue.
Each owner is insured with a total of $1,000,000, their share of the business. If an owner dies, each of the surviving owners uses the $500,000 death benefit to purchase the total $1,000,000 share from the deceased owner’s estate.
It’s advisable to use cross-purchase agreements when the owners are relatively the same age. This is because the life insurance premiums insuring a young person are vastly different than they would be on an older person. It wouldn’t be fair if a 35-year-old co-owner was paying policy premiums on a 65-year-old co-owner.
In addition, a cross-purchase agreement is best if there are only a few owners involved. With the example above, there are six total life insurance policies for three owners. Imagine if the company had six owners. Then there would be a total of 30 life insurance policies since each owner needs to own a policy on every single other owner. This can get quite complex and a lot to manage.
For businesses that have a wide disparity of owner ages or multiple owners, an entity-purchase buy-sell agreement would be best.
Entity-Purchase Buy-Sell Agreements
An entity-purchase buy-sell agreement is ideal if there are many business owners or if the owners’ ages are vastly different.
How does an entity-purchase buy-sell agreement work?
With an entity-purchase buy-sell, the business entity agrees to buy a deceased owner’s interest from the deceased’s owner’s estate for a pre-determined price.
The business needs each owner’s consent to purchase a life insurance policy on their life. The insurance coverage amount should equal the purchase price for that owner’s share of the business.
The business also has access to the policies’ cash values in an entity-purchase buy-sell agreement. Typically with the cross-purchase and one-way buy-sells, this isn’t allowed.
Buy-sell agreements are so important for a business. They ensure a smooth transition of ownership after a potentially disruptive event.
Buy-sells funded with life insurance solve three problems:
- Establishing a price for the business interest,
- Securing a buyer,
- Ensuring there are funds to complete the terms.
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