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.
Shares transferred to a prohibited shareholder terminate the S tax status and the business is taxed as a regular C corporation. A buy-sell agreement requires that stock be transferred only to eligible S corporation shareholders.
For the deceased owner’s estate/heir, a buy-sell agreement:
o Creates a market for the deceased owner’s interest. Closely held business owners often have difficulty locating a willing buyer for their interest, which sometimes forces an estate to sell the interest for below-market value. An enforceable buy-sell ensures that a buyer is available and that the “price is right.”
o Establishes the value of the interest for federal estate tax purposes. An “arms length” negotiated value documented in the agreement helps to establish business value at an owner’s death, reducing the possibility of an IRS challenge.
o Provides for increased efficiency in the administration of the owner’s estate. Since the terms of the sale have been completed during the life of the owner, a buy-sell will prevent delays in the administration of the estate. And it will help to alleviate other disputes between the deceased owner’s heirs and the surviving business owners.
o Relieves the heirs of the estate from the affairs of the business. Heirs who are not participating in the business may not want to be exposed to the ongoing risks of operating a business. A funded buy-sell arrangement can ensure that disinterested heirs are bought out and protected from business risks.
o Avoids negotiating price and terms when the estate may be in a weak bargaining position. The lack of a buy-sell agreement prior to an owner’s death alters the negotiation playing field. When an estate is facing administrative and tax costs and has few liquid assets, a “fire sale” may be the result.
For the surviving owners, a buy-sell agreement:
o Helps to prevent disputes between heirs of the deceased (inactive) owners and the surviving, active owners. Disputes commonly occur from the clash of passive owners’ short-term goals (favoring return on investment and frequent distributions) with the long-term view of active owners who are typically more interested in retaining funds to grow the business. Both parties’ objectives can be met if a funded buy-sell agreement is in place and inactive heirs are bought out.
o Helps avoid a moral dilemma that could arise from negotiating with the spouse and children of a deceased owner. While the personal feelings of the surviving owners might lean toward “generosity,” they have a fiduciary duty to the business and an obligation to their creditors. The pre-arrangement assures that all parties to the transaction receive the needed funds to continue on.
A buy-sell arrangement can ensure the business will continue and can help eliminate difficulties and uncertainties for the remaining owner(s) and heirs. However, the best-documented plan may fall by the wayside without adequate funding. The solution: life insurance.
While providing needed funds at an untimely death, life insurance can be the most economical method of prepaying the purchase of the business, as small premium dollars generate lump sum, income-tax free death benefits under IRC ? 101(a).
Terri Getman, JD, CLU, ChFC, is vice president, advanced marketing, at Prudential Financial, Newark, N.J. You can e-mail her at firstname.lastname@example.org.
A well-written buy-sell agreement, paired with a life insurance policy, can help make the transition painless