Controlling Your Destiny with a Buy-Sell Agreement

Buy-sell agreements can be powerful tools to help you control your business’s destiny. These contractual agreements typically involve shareholders and their corporation or are executed between a shareholder and the other corporate shareholders. Partners or limited liability company (L.L.C) members can also enter into buy-sell agreements.

A buy-sell agreement controls what happens to a business when a specified event occurs, such as a shareholder’s death or disability. An agreement might provide that, when a shareholder dies, the corporation will buy back the stock (a redemption plan) or that one or more of the remaining shareholders will buy the stock from the deceased’s estate (a cross-purchase plan).

A well-drafted buy-sell agreement can help solve several estate planning problems for the owner of a closely held business. An agreement also may help protect and preserve the business against internal squabbles, whether among family members or unrelated business owners.

A key issue with any buy-sell agreement is providing the buyer with a means of funding the purchase. Life or disability insurance often fulfills this need. Using insurance to fund a buy-sell agreement can give rise to several tax and non-tax issues and opportunities.

I have a client who owns a small business with multiple family members. They were disabled for a limited period of time. They actually suffered from a catastrophic medical condition that left them mentally disabled for about 9 months. The family does not like the first and only wife. They treated her very poorly and started to bully her out of the business trying to force her to give up her husbands interests during a time he could not defend himself. The clients buy/sell agreement protected her and her rights in the company to the point that the family began to recognize that if they pushed too hard she was going to exercise the force clause allowing her to fire them.

Thankfully the client has recovered and is beginning to take the company back over. We are now adjusting his buy/sell to handle disability as well as death or sale.

Planning tip 2Potential Benefits of a Buy-Sell AgreementBuy-sell agreements can be quite powerful. Among other qualities, a well-drafted agreement:

  • Provides a ready market for the shares if the owner’s estate wants to sell the stock after the owner’s death.
  • Sets a price for the shares. In the right circumstances, it also fixes the value for estate tax purposes.
  • Allows a stable continuation of the business by preventing unnecessary disagreements caused by new, unwanted owners.

Because shareholders typically expect a business’s value to rise, the price under the buy-sell agreement will likely also change. Thus, funding through insurance must be adjusted over time and periodically reviewed to ensure adequate coverage.

Life Insurance and Income Tax

Life insurance proceeds generally are excluded from the beneficiary’s taxable income, whether the beneficiary is a corporation, another shareholder or a separate entity. An exception is the transfer for value rule, under which proceeds will be taxable if an existing policy was acquired for value by someone other than the insured or a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or shareholder.

This issue often arises when structuring or changing a buy-sell agreement using existing insurance policies. Be careful to structure the agreement so that the transfer for value rule will not have an impact; otherwise the amount of after tax insurance proceeds will be reduced.

The other side of the income tax equation is that life insurance premiums are not tax deductible in a buy-sell situation, even though they are being paid to accomplish a clear business purpose.

Redemption Agreements

With a redemption agreement, the corporation itself buys back a shareholder’s stock. Thus, this type of agreement proportionately increases each remaining shareholder’s ownership. This may or may not be the desired result, because a big difference may lie between what each shareholder wants and what each will end up with under a redemption plan. If a proportionate distribution of shares is not the goal of your buy-sell agreement, you may want to use a more flexible cross purchase plan.

A redemption does not provide the remaining shareholders of a C corporation with an additional tax basis in their newly acquired stock. Assume, for example, that two 50% shareholders each paid $500 for their stock when they started a business. When Shareholder One dies, his stock is redeemed for $1 million. Shareholder Two (now the 100% shareholder) still has a tax basis of $500 in her stock. By contrast, under a cross purchase arrangement, Shareholder Two’s stock would now have a tax basis of $1,000,500.

Redemption also can cause a potential income tax problem for C corporations, because receiving life insurance proceeds, while not taxable for regular tax purposes, can result in additional tax under the corporate alternative minimum tax (AMT). When insurance proceeds are large in relation to a business’s net income, the AMT could be substantial. This often occurs in shareholder buyouts.

Chart 2

Does a redemption produce the desired results?

Shareholder Ownershipbefore buyout Hypotheticaldesired result After redemptionof the stock of A
A
45%
B
45%
90%
82%
C
10%
10%
18%

Cross-Purchase Agreements

To avoid the potential pitfalls of a redemption plan, consider using a cross purchase arrangement instead. In a business with only two shareholders, a cross purchase plan is relatively simple: Each owner need only apply for and hold a life insurance policy on the other. As the number of shareholders grows, however, the number of policies involved increases dramatically. Three shareholders would need six policies (each shareholder would have policies on the two others), while a business with six shareholders would need 30 policies. This need for multiple insurance policies, paid for outside of the business, creates the complexity that has traditionally been cross purchase agreements’ major drawback.

Of course, shareholders spend their own money every year for these insurance costs. Premiums will vary for each policy — sometimes significantly — depending on each individual’s age and other insurance rating factors, as well as his or her ownership percentage. Such amounts can generally be paid as additional compensation to each shareholder, but to fully cover the cost, the additional compensation would have to be “grossed up” (see Chart 3).

Chart 3

Gross-up of additional compensation

Cash compensation
$1,667*
Income and payroll taxes (40%)
$(667)
Net cash to shareholder
$1,000
* For a $1,000 insurance premium

Yet in businesses with very disproportionate shareholdings, such as 90/10, it may not be fair to the majority shareholder if the company funds the insurance (either directly or through salaries). In such cases, the 90% shareholder would effectively pay 90% of insurance costs on his or her own life and thus end up paying for most of his or her own buyout. You will need to closely examine the overall agreement’s economics to understand how it will affect those involved.

In a cross purchase agreement, the party who receives the proceeds should maintain the policy. The insured, however, is the one who will suffer if a policy lapses and leaves insufficient funds for the purchase of his or her share of the business. Yet many agreements fail to provide a means to notify the insured if premiums are not being paid. This problem can usually be solved by verifying that each policy owner has provided evidence to the insured that premiums have been paid and permitting the insured to pay premiums and then seek reimbursement.

Wait-and-See Buy-Sell Agreements

Deciding between a redemption and a cross purchase agreement can be difficult. There are many variables: Not only can the business’s and shareholders’ circumstances change, but so can the tax laws. The “wait and see” agreement offers more flexibility. Unlike other buy sell agreements, the purchaser is not specifically identified. The shareholders, the business or both can buy life insurance. When a shareholder dies, the business has the first option to buy the stock. If the business opts not to buy or to buy only some of the stock, the shareholders have the option to buy. The business must buy any remaining stock.

Using a Partnership to Hold Insurance

Partnerships have become an excellent way to address some of the issues with buy sell agreements. The partnership can own — and handle the premium payments on — all policies. Because there is one central entity, only one policy per person is required. And because of a specific exemption, the transfer for value rule is not a problem. (This is not the case for trusteed or escrowed agreements, under which a trust or escrow agent — rather than a partnership — holds all policies.) A clear business purpose, apart from the ownership of life insurance, must be shown for the partnership’s existence.