For many business owners, the focus is on today: running the business, managing day-to-day operations, and growing revenues. Most business owners can’t imagine the day when they will be unable to participate in their business.
Nevertheless, that day arrives sooner or later, and owners need to plan for the continuation and control of their business. Without proper planning, death, disability or retirement can create chaos for all parties involved. However, a well-written buy-sell agreement, paired with a life insurance policy, can help make the transition painless.
The decision to select a cross purchase or entity purchase agreement depends largely on the collective goals of the owners and the tax considerations inherent in the structure of the entity. These considerations should be explored early in the sales process.
Each plan has its advantages, but in many cases either plan will deliver desired results. Often, the psychological comfort level of the business owners tips the balance. Among things to consider are:
o The number of owners. More than three owners might consider an entity purchase requiring only one policy per owner for ease of administration.
o Disparity in owners’ age or health. An entity plan allows the partners to share equally in the cost of insurance.
o Desire to protect personal assets from the company’s liability. The policy value exists outside of the business in a cross purchase plan.
o Desire to preserve the “step up in basis” in a non-flow-through entity. This can be achieved in a cross purchase plan.
Let’s look at the benefits of a buy-sell funded with life insurance. For the business entity, the agreement:
o Enables the execution of a smooth transition in the control and ownership of the entity. That allows the business to remain in good standing with clients, creditors and employees.
o Permits surviving owner(s) to begin transferring ownership and control of the business before the triggering event (i.e., an owner’s death).
o Prevents unwanted parties from acquiring an ownership interest. Proper planning will help preclude meddling family members or third-party competitors from acquiring and/or having involvement in the daily decision-making of the business.
o Provides an independent mechanism for determining a price or pricing formula for the business interest, decreasing the potential for disputes. It is simpler for all parties to negotiate payment terms before the fact, when presumably no party is operating from a position of weakness and emotions are not at a high.
A buy-sell agreement sets pricing parameters prior to the event; flexible drafting can give “first rights of purchase” to family members, ensuring they are given priority over third-party buyers.
o Helps avoid transfers that could negatively impact the business entity’s formation or tax status. Tax rules may dictate which individuals or entities can have an ownership interest in a business structured as an S corporation.