WHAT is a Buy-Sell Agreement? It is an agreement typically between the owners or the entity and the owners for the purchase of the business interest upon the occurrence of certain triggering events (discussed further below). Most companies with more than one owner also restrict the transfer or ownership of the business interest through a buy-sell agreement. There are three (3) common buy-sell arrangements:
1) Cross-Purchase. In this arrangement, the owners of the business interest (e.g., shares of stock of a corporation or membership interest of a limited liability company) agree to buy each other’s business interest upon the occurrence of certain triggering events (e.g., death or disability) (further discussed below). By entering into this arrangement, the owners agree to buy, or has the option to buy, the deceased or withdrawing owner’s business interest in the entity. Generally, the purchase of the business interest is funded with the insurance proceeds from the life insurance policies on the deceased owner’s life. A drawback from this arrangement may be the unequal payment of premiums of policies due to different insurability factors. Careful planning may reduce the disparity in the life insurance premiums paid by the business owners. There are several advantages of entering into this arrangement. One advantage is in the event of death of an owner, the purchasing owners will receive a step-up in basis in the deceased owner’s business interest. A step-up in basis may reduce the amount of capital gains in the future sale of the business entity. Another advantage is the minimization of the alternative minimum tax and the accumulated earnings tax. The tax effect of each transaction depends on the circumstances of the transaction and requires careful review and planning.
2) Redemption. This arrangement provides for the purchase of the business interest of the interest holder by the business entity upon the occurrence of a triggering event (discussed below). For example, in the context of a corporation, a redemption agreement provides for the purchase by the corporation of a shareholder’s shares of stock of the corporation upon a triggering event. The business entity may use life insurance to fund the purchase of the business interest. Because the business entity (not the business owner) purchases or has the option to purchase the business interest, only one life insurance policy is needed per business owner. An advantage of this arrangement is the relief of the requirement of the remaining owners to purchase the interest, and thus, no need to obtain life insurance policies on the lives of the other owners. Several disadvantages from this arrangement include, but is not limited to, the following: no step-up in basis, dividend treatment from the redemption, and alternative minimum tax and accumulated earnings tax effects. Please contact our firm if you want more information regarding these adverse tax effects.
3) Hybrid Redemption and Cross-Purchase. In this arrangement, either the business entity or the business owners will be obligated or have the option to purchase the interest of the interest holder upon the occurrence of a triggering event (discussed below). There are several ways that this arrangement may be structured. A common structure is for the cross-purchase of the interest from the interest holder, and in the event that the option for such cross-purchase is not exercised, then the business entity has the option to purchase the interest from the interest holder. Another arrangement is to give the business entity the first option to purchase the interest from the interest holder, and then upon the failure to exercise, to permit the business owners to purchase the interest from the interest holder. Other strategies may be utilized to reduce the tax effects from the purchase. Please call our firm to discuss other structures that may be applicable to your business.
What are the triggering events? These are events that will cause a disruption in your business and may result in the cessation of your business or the sale of your business. The following are common triggering events:
- Withdrawal; and
Planning for each of the foregoing triggering events require you to think about who will continue to operate the business, the valuation of your interest, how your interest in the business will be paid, and the tax effects resulting from the sale and from the purchase of your business interest.
If a Buy-Sell Agreement has not already been prepared for your business entity and one is desired, please feel free to contact us to discuss the various issues involved.