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Buy-Sell Agreements

A Number of Advantages

A buy-sell agreement is a legally binding contract that requires action upon the occurrence of a business owner or shareholder’s retirement, death, or long-term disability. There are a number of important advantages of a buy-sell agreement. When properly designed, they can guarantee a buyer for a business, establish a value for federal estate purposes that is binding on the IRS, and spell out the terms of payment. A buy-sell agreement is easily funded with life and disability insurance to provide a smooth transition of control and ownership to those best equipped to keep the business going.

The methods of funding a buy-sell agreement include: personal funds to purchase the business, the sinking fund of the business, borrowed funds, installment payments to the heirs by the buyer, or life insurance. Life insurance is generally the most economical and cost effective method of funding. It provides complete financing guaranteed from the beginning and death benefits are generally tax-free. If permanent insurance with a cash value element is used, the cash values can be used for buyout due to retirement or disability. In addition, the business’ credit position is strengthened.

There are two major types of buy-sell agreements. These include cross purchase agreements and stock redemption agreements. Cross purchase agreements are used when the remaining shareholders will be the purchasing parties. Each remaining shareholder buys the agreed upon portion of the stock of the departing shareholder. The number of policies needed in a cross purchase agreement can be determined by the following formula: policies needed = x(x-1) where x is the number of partners. Stock redemption agreements are used when the corporation is the purchasing party and buys the agreed upon number of shares of the departing shareholder. These plans are also referred to as entity purchase plans. Under this arrangement, the seller receives cash and/or notes and corporation receives stock. The amount of insurance on each stockholder equals the proportionate share of the purchase price. Upon the death of a stockholder, the death benefits are paid to the corporation who then buy the deceased’s stock from the deceased’s estate. Premiums are not tax deductible, but the proceeds are received income tax free.

A buy-sell agreement concentrates on one of the most economically troublesome problems that the death or long-term disability of business owner or shareholder creates. At death or disability, the choice to sell the business, give it away, or keep it is gone. The death or disability of an owner or majority shareholder may mean the death of the business. Conflicts of interest can also pose a big problem for closely held businesses. These conflicts may threaten the life of a corporation, as well as their business and personal relationships. Surviving stockholders seek to maintain their jobs and salaries, fringe benefits, bonuses, and other advantages as well as prevent outsiders from interfering or seizing control of business affairs. They want to ensure that the ownership of a corporation does not move outside the agreed-upon group of entrepreneurs, prevent a former shareholder from competing with the business, and protect against shifts in proportionate ownership. The shareholder’s family has different goals. Dividends may become a major source of income. The family may also need income in order to pay estate administration expenses and taxes. Some heirs may not have an interest in the business or may lack the skills required to manage it. If heirs do not have the skills to manage the business, they may still be interested in voicing as much control as possible in the business and may not want their financial future in the hands of the surviving shareholders.

It is important for business owners to understand nature and scope of potential problems and the importance of a buy-sell agreement in the problems a closely held business may face. Buy-sell agreements can resolve these important issues for business owners and give them the peace of mind that comes with a sound financial business plan. Life and disability insurance can guarantee the funding mechanism to make this transition affordable and fair to the parties involved

Article Date: 
2010 December