As an advisor to business owners, you help them identify a way to transition out of their business, when to sell and to whom, how to structure the sale and how to determine the purchase price. Transferring a business generally falls into one of two categories: (1) transfer the business itself or (2) transfer the financial benefits of the business.

Keeping it in the family

Many business owners are likely to see the business continuing in the hands of family members only and may not have thought about outside ownership. If there are family members, such as a son or daughter ready to take over, then the transition may be an easy one. The next owner should be someone who fits the position and is on the way to having all the skills necessary to take over the business.

In the second scenario, the business owner wants to exchange the business for financial benefits. The business interest may be sold to the remaining owner(s), a key employee or an outside party. The owner typically plans to use the sale proceeds to meet his or her retirement income needs or to provide for his or her family’s survivor income needs.

Once the business owner has decided what he or she would like to happen to the business and has a transition plan in mind, the next step is to put the plan in writing. This is accomplished using a buy-sell agreement, a legal contract for the future sale of a business. It is legally binding and sets the terms and conditions for the sale.

While there are several ways to structure a buy-sell agreement, this article will focus on a cross-purchase buy-sell with existing owners, funded with life insurance. Each owner purchases an insurance policy on the life of the other business owner with after-tax dollars; and each is both owner and beneficiary of the policy. At the death of the first business owner, the remaining owner uses the death benefit proceeds to buy out the deceased owner’s interest in the business. This is a case where a well-designed and funded agreement allows for the smooth transition of the business interest, with the deceased owners estate receiving a fair price for his or her share of the business.

But what happens when there are multiple owners? The number of policies needed to fully fund the agreement can be onerous. Each owner would need to purchase a policy on the life of each other owner. The formula for determining the number needed is “N x (N-1)” where “N” is the number of owners. For example, in a business with 3 owners, 6 policies would be needed (3 x 2). If there are 4 owners, 12 policies are needed.

Enter the trust

To avoid this problem, the owners may choose to use a “trusteed” cross-purchase agreement: a contract with the addition of a third party–the trustee–to ensure that the agreement is carried out. The trusteed cross-purchase agreement avoids the disadvantage of each owner having to purchase a life insurance policy on every other owner. The trustee is the owner and the beneficiary of one life insurance policy on each owner. Each business owner contributes his/her share of the premium to the trustee in proportion to his/her ownership interest.

The sale of the business is overseen by the trustee, who is responsible for seeing that the obligations are carried out between the departing owner (or his or her estate) and the buyers. The trustee is a neutral party and handles all the administrative issues and monitors the funding.

The trustee can be an individual, such as a lawyer or a CPA or a corporate trustee, but should be a disinterested and impartial third party. At the death of an owner, the trustee collects the insurance proceeds and pays the purchase price to the decedent’s estate in exchange for his or her ownership interest, which is then distributed to the remaining owners in proportion to their ownership interest.

A trusteed cross-purchase agreement can also eliminate some of the complexity in situations where age, insurability or unequal ownership interest can create a huge disparity in premiums. For example, Owner A is a 62-year old with a 46% ownership interest in the business. Owners B and C, both in their 40s, equally own the remaining interest in the business. For simplicity, if the total premium for all 3 owners equaled $30,000, Owner A will contribute $13,800 and Owners B and C will each contribute $8,100.

Due to the fact that there are no incidents of ownership (because the trustee is owner and beneficiary of the policies) the value of the policy will not be included in the decedent’s estate. If the business is a C-corporation, because the individual owners are the parties to the sale and no company money is being used, the transaction is not considered a dividend payment.

The trusteed cross-purchase agreement also avoids application of the family attribution rules. There is one hidden tax liability to be aware of: When the policy interest is reallocated after the death of an owner, there is a transfer-for-value issue that could jeopardize the income tax-free nature of the insurance death benefit. There are several exceptions to the transfer for value rule and anyone considering this method of funding should consult with legal and tax advisors.

Tabulating the benefits

A buy-sell agreement can help to maintain stability, improve the creditworthiness of the business and provide security for the owner’s family. It also can meet liquidity and survivor income needs, set the terms of the sale when all parties have equal bargaining power and establish estate tax value, which helps avoid unexpected estate tax liability. A trusteed arrangement has the added benefit of simplifying a sometimes complex situation.