Article: Designing the Right Buy-Sell Agreement

Designing the right buy-sell agreement

For co-owners, the question isn’t "should we?" – it’s "what type?"

If you're a shareholder in a closely held business, creating or updating your buy-sell agreement can give you greater control over your financial interests. A properly written agreement can help you address a variety of issues, including taxes, buyouts, payment terms and more. Here are some of your options when considering what is best for you.

Funding buyouts. In many cases, insurance policies on the lives of one or more shareholders can provide some or all of the cash resources needed to implement the buy-sell plan at a shareholder’s death. While there is a real cost to using life insurance, the alternatives may be more costly. Funding a purchase in the absence of insurance can cash-strap your company or force it to take on major debt.

When a buyout is triggered by an event other than death, installment payments may be advisable. This allows the buyer to secure financing or fund the buyout through company earnings.

Typical triggering events besides death are disability and employment termination, but others also may be included in the agreement. For example, an act that discredits the company and may result in felony conviction, such as embezzlement or fraud, may be a triggering event. In fact, some buy-sell agreements have "bad boy" clauses which, when triggered, establish a low buyout price.

Choosing an appropriate agreement. For buyouts triggered by death, there are two basic types of buy-sell agreements: the stock-redemption agreement and the cross-purchase agreement. Variations and mixes of these arrangements may be necessary to accomplish shareholder objectives.

Redemption agreements. In a typical stock redemption arrangement, the business owns insurance policies on the lives of each shareholder, and the shareholders enter into an agreement with the business. For example, Lee, Pat and Chris – equal shareholders in LPC, Inc. – entered into the following agreement with the company: On Lee’s death, LPC collects life insurance proceeds and uses them to buy Lee’s stock from his estate. Lee’s estate now has liquidity, and Pat and Chris each owns 50% of LPC. Here are some important considerations:

One policy is generally needed for each shareholder (first-to-die policies are available to insure two or more lives).
The business owns, pays for and controls the policies.
The policies are subject to the claims of the business’s creditors.
Because the business is the purchaser of the decedent’s shares, the remaining shareholders do not get a step-up in their tax basis as a result of the purchase.
Dividend treatment can result from stock redemption in a family business because of family attribution rules, unless specific conditions are met.
Alternative minimum tax may apply for other than a "small business" corporation.

Cross purchase agreements. In a typical cross-purchase agreement, the business is not directly involved. Each shareholder buys a policy on the life of every other shareholder, and all shareholders enter into a purchase agreement.

Using the same example as before, Lee would own one policy on Pat and one on Chris. Pat would own one policy on Lee and one on Chris. And Chris would own one policy on Lee and one on Pat. On Lee’s death, Pat and Chris would use the proceeds from their policies on Lee to each buy 50% of Lee’s stock from Lee’s estate. Again, the estate now has liquidity, and Pat and Chris each owns 50% of LPC. Again, here are some important considerations:

Multiple policies are needed. The total number needed is equal to n(n-1), where n equals the number of shareholders (e.g., six separate policies are needed for Lee, Pat and Chris).

The shareholders own, pay for and control the policies.
The policies are subject to the claims of the owning shareholders’ creditors.
Each purchasing shareholder receives a step-up in basis for the acquired shares.
No dividend is issued on the sale because family attribution rules do not apply.
No alternative minimum tax is incurred because life insurance proceeds are not paid to the corporation.

Whether you should use a stock-redemption or a cross-purchase agreement depends on many factors, including overall premium expense, sources of funds to pay premiums, enforcement of the agreement, the importance of step-up in basis, perceived simplicity, and the shareholders’ primary objectives. Another consideration, at least in connection with a redemption arrangement, is whether the life insurance should be reflected in the purchase price of the stock. In most cases, the cash value of the policies, not the death proceeds, are considered part of the business’s assets.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.