Six Reasons Business Owners Need A Buy-Sell Agreement
Do you have difficulty approaching businesses where you may have a friend or other contact? If only you had an approach that they cant “shut the door on” as soon as you get started. You need something that really appeals to the business owners financial well-being.
Enter the buy-sell agreement, an absolutely essential part of any business owners planning, regardless of the form of the business. Only with an up-to-date, and funded, buy-sell agreement can an owner of a business interest be assured that:
a) The surviving owners can take over the deceaseds interest quickly and efficiently, with minimal disruption to the day-to-day operation of the business; and,
b) The family of the deceased will receive fair value for their loved ones interest on a timely basis without the need for drawn-out negotiations and/or litigation.
There are six key reasons for a buy-sell agreement:
1. Retirement. A buy-sell agreement helps assure a comfortable retirement for the business owner. After spending an entire lifetime developing the business, a retiring owner can be assured that his interest will be bought out on agreed-upon terms for fair value. Generally, a retiring owner does not want to stay involved with the business and would like some (legally enforceable) certainty as to how he will be paid for his business interest.
2. Guaranteed market. A buy-sell agreement protects the owners family from both the cost and delay of selling the business and the weak bargaining position of being a non-active surviving spouse. By creating a guaranteed market for the business interest at a predetermined price, the surviving family members are freed from the difficult task of selling a business interest where they have little or no knowledge of the business.
3. Surviving owners. A buy-sell agreement allows the surviving owners to move forward with business activities without the drag of either a “silent partner” or protracted litigation. The last thing the surviving owners want is to have to negotiate with a surviving spouse who wants maximum cash flow, at a time when the business may need to reinvest capital to reassure creditors and suppliers of its ongoing economic viability.
4. Reassuring others. A buy-sell agreement reassures employees, suppliers, and creditors that the business has a viable plan for continuing to do business despite the loss of an owner. The named players can rightly be concerned about the future of the business in situations where a lack of planning leads to a significant financial strain on the business from litigation, etc.
5. Business valuation. A buy-sell agreement helps set a value of the business interest for estate tax purposes, thereby possibly avoiding a long, drawn-out dispute with the IRS over the value of the business. Where non-family members are involved, the service will give great weight to the valuation determined in the buy-sell agreement. This may help avoid the need for costly valuation reports and protracted litigation with the IRS over the appropriate value to put on the deceaseds interest.
6. Professional organizations. A buy-sell agreement that is current is essential for professional organizations since they cannot, by law, be owned by non-licensed individuals. For example, if Dr. Jones dies, his wife must dispose of her interest soon after his death. Talk about a lack of negotiating leverage! While a business owner may appreciate his fellow owners company while he is alive, business realities may cause him to “low ball” the value of the offer made to the surviving spouse.
Given these reasons, its in the mutual best interest of both the owners family and the survivors to have an orderly plan of transition in-force in the event of retirement or death. Its even better if the plan is funded with life insurance, so the dollars will be there to buy out the interest without impairing either the capital or the cash flow of the business going forward. Life insurance is often the most cost-effective solution for funding the buy-sell agreement.
As you are aware, there are a number of ways to structure the arrangement. The business can agree to buy the interest, known as an entity purchase or stock redemption plan. Its funded with business-owned life insurance. This is a simple solution, but it does not provide a step-up in tax basis for the survivors and may cause problems with corporate alternative minimum tax and family attribution rules.
The co-owners can buy the business from the retiring owner or estate. This is known as a cross-purchase plan, and it does provide a step-up in tax basis to the survivors. Its funded with policies owned by each of the owners, but if the number of owners gets large, it may become unwieldy. For example, if there are six owners, a total of 30 policies would be required.
This problem can be solved by using a trusteed cross purchase in which a third party serves as custodian of one policy on each owner, held for the benefit of the non-insureds. Taxation is the same as if each owner controlled the policies herself on the lives of the others.
Finally, for the business owner who cant decide on any of these options, we have the wait-and-see buy-sell plan, which allows the decision on how to redeem the ownership interest to be put off until the future when the buy-out takes place. This is also an effective technique where the company starts with an entity purchase plan but wants additional coverage to be funded on a cross-purchase basis.
As you can see, the buy-sell approach is one that should be of interest to all business owners. Try it on your next business call.
Pat Lang, JD, CFP, CLU, ChFC, CFS, FLMI, is vice president, advanced sales – case design and support at Jefferson-Pilot Financial, Greensboro, N.C. He can be reached via e-mail at patrick.lang
Reproduced from National Underwriter Life & Health/Financial Services Edition, September 23, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.