Structuring An Effective Management Team Buy-Out

What can a sole business owner do if there are no successor owners or family members to take over the business when he or she retires, dies or becomes disabled? A management team buy-out may provide a solution.

A business succession plan provides the business owner the assurance that a successor owner will purchase the business at a mutually agreed upon time and price. Such a plan provides security and predictability. When a business has multiple owners, the natural successors to own and operate the business are the owners who remain after an owner dies, retires or becomes permanently disabled. In family businesses, the next generation of family members usually is called upon to provide successor ownership and management.

But when there is a sole principal owner and no family member to succeed that owner, possible successors include key employees and managers who actively are involved in the business.

One problem with creating a buy-sell agreement between the principal owner and key executives who form the management team of a business is that the management team does not remain constant. These executives often come and go as professional opportunities present themselves. How can the owner be assured that the key executives on the management team will buy the business when the owner wants to, or must, sell out? And just as important, where will the executives get the money to buy the business?

The owner and management team can enter into a buy-sell agreement that obligates the management team to purchase the owners business interests at a price established in the agreement whenever certain “trigger” events occur–such as the owners death, permanent disability or retirement.

To provide the security and predictability the owner needs, and the flexibility the executives need to enter and leave the business (and the management team buy-out agreement), the parties can create a trust or partnership that has the obligation to purchase the business interest when a trigger event occurs. The executives, or management team, would be the beneficiaries of the trust or partners in the partnership.

When a triggering event occurs, the trust or partnership would buy the principal owners business interests. Once the transaction is complete, the trust or partnership would distribute the business interests–usually stock–to the beneficiaries or partners.

Funding The Buy-Out. An installment sale can be used in which the management team pays the departing owner over a period of years from business revenues. This, however, requires the owner to spread out the receipt of his or her money and creates the possibility that the business, and the source of the payments, may fail once the owner no longer has control. For lifetime buy-outs because of the principal owners retirement or disability, an installment sale may be the only practical way to structure the arrangement.

The engine that moves most buy-out arrangements to satisfactory completion is life insurance. The best way to provide a lump sum for a buy-out at death is by funding it with life insurance because the death benefits become available in cash when the need arises. Life insurance cash values may also be used to provide part or all of the needed cash for a lifetime buy-out occurring at the principal owners retirement or disability.

In a management team buy-out, a trust or partnership would own a policy on the principal owners life. Subject to a split-dollar agreement between the business and the trust or partnership, the business would pay the premiums and take back a limited collateral assignment for the cumulative premiums paid (under loan regime split-dollar) or the entire cash value (under economic benefit split-dollar where there is no equity element owned by the trust or partnership). The limited assignment, which prohibits the business from accessing the assigned cash values, would keep the proceeds out of the estate of the insured owner.

Using amounts contributed by or imputed to the management team members, the trust or partnership would pay or be charged the appropriate term costs or loan interest due under the split-dollar agreement.

The split-dollar arrangement keeps only “term” insurance in the trust or partnership, thus allowing members of the management team to change from time to time without new members having to buy out the interest of the outgoing management team members interests in the trust or partnership.

When the policys cash values, which have been assigned to the business, are needed to effect a buy-out at retirement or disability, the business can lend the money to the trust or partnership and the buy-out can be consummated. If there is not enough cash available to complete the buy-out, the cash can be used as a down payment and the rest of the buy-out can be done through an installment sale.

Once the management team owns the business, they can either pay back the business over time or the business can forgive the loan as a taxable bonus to the executives.

Avoiding Transfer-for-Value. The primary obstacle to overcome in structuring a management team buy-out is the transfer-for-value rule, which, if applicable, would cause most of the proceeds to be subject to income taxation. If a general partnership is used to own the life insurance, the business owner should own a 1% interest in the partnership. Transfers to a partnership in which the insured is a partner is one of the exceptions to the transfer-for-value rule. If a trust is used to own the policy on the life of the principal owner and effect the buy-out, the management team should form or participate in a separate partnership with the insured owner. Seeking legal guidance for the clients individual circumstances on this issue is critical.

Richard C. Baier, J.D., CLU, ChFC, FLMI, is assistant vice president–advanced sales with Jefferson Pilot Financial, Greensboro, N.C. He can be reached at richard.baier@jpfinancial.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 15, 2003. Copyright 2003 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.