Creative Financing – Designing and Funding A Buy-Sell Agreement for your Business

Estate Planner Jan-Feb 2006

If you own a business, it’s probably your most valuable asset. So it’s important to take steps to preserve that value for your family after your death or in case you become disabled or leave the business for some other reason. One of the most powerful tools available to help you achieve that goal is a buy-sell agreement.

A buy-sell agreement creates a market for your interest in the business, providing liquidity to pay estate taxes and other expenses, and smoothing the transition from one generation to the next. Because the agreement provides for the company or the other owners to buy you out, it’s critical to make arrangements to fund the purchase.

Buy-sell benefits

A buy-sell agreement is a contract among the owners of a business that provides for the company or the remaining owners to buy back a deceased, disabled or departing owner’s interest under specified circumstances for a specified price. Typical “trigger events” include:

· Death,
· Disability,
· Divorce,
· Retirement or termination of employment,
· Bankruptcy, and
· Loss of a professional license.

By establishing buyout terms, a buy-sell agreement creates a market for otherwise unmarketable shares, providing a source of liquid funds the owner’s heirs can use to pay estate taxes and other expenses without being forced to sell the business.

A buy-sell agreement also can help keep ownership of the business within a family or another select group by preventing: 1) departing owners from selling their interests to outsiders, and 2) an owner’s spouse from acquiring an interest in a divorce proceeding.

Other potential benefits of a buy-sell agreement include minimizing disputes among owners over price and other buyout terms, and establishing the value of the business for gift and estate tax purposes (if certain requirements are met).

Types of agreements

There are two basic types of buy-sell agreements: redemption and cross-purchase. Under a redemption agreement, the company buys back a departing owner’s interest, and under a cross-purchase agreement, the remaining owners purchase the interest. Each has advantages and disadvantages:

Redemption agreements. An important distinction of a redemption agreement is that the company is responsible for funding the buyout, not the other owners. Redemption agreements have some big drawbacks, especially if the company is a C corporation. For one thing, if a redemption agreement is funded by insurance on the owners’ lives, insurance proceeds received by the company may trigger corporate alternative minimum tax (AMT). The company can avoid AMT by funding the agreement with corporate savings rather than life insurance, but this approach can create accumulated earnings tax (AET) issues.

Another disadvantage of a redemption agreement is that the company’s purchase of an owner’s interest enhances the value of the remaining owners’ shares – because each owner now owns a greater percentage of the company – without a corresponding step-up in tax basis. A lower tax basis potentially increases the tax hit for owners who later sell their interests.

Cross-purchase agreements. These agreements can provide several advantages but can be unwieldy and expensive – especially for larger companies – because each owner must maintain insurance policies on the lives of all of the other owners. On the plus side, however, in addition to avoiding AMT and AET problems, cross-purchase arrangements provide the remaining owners with additional tax basis in any acquired interests, reducing their capital gains – and, therefore, their taxes – if they sell their shares.

Considerations for pass-through entities

The disadvantages of redemption agreements are generally less of a concern for pass-through entities – such as S corporations, partnerships and limited liability companies – because they’re not subject to AMT or AET.

Also, there is less of a basis issue on pass-through entities. Like a C corporation, a pass-through entity’s buyout of a deceased or retiring owner doesn’t produce a basis increase for the surviving owners. But if the buy-sell agreement is funded by life insurance, the basis of all owners is increased by the pass-through entity’s receipt of the insurance proceeds.

For example, Tom, Dick and Harriet each own one-third of the stock of TDH Advisors, an S corporation valued at $3.6 million. Under a cross-purchase agreement, if one of the shareholders dies, the other two are obligated to buy back the shares for $1.2 million. To fund the agreement, Tom, Dick and Harriet each buy $600,000 life insurance policies on the lives of the other two shareholders. When Tom dies, Dick and Harriet each collect $600,000 in life insurance proceeds tax-free and use those funds to buy half of Tom’s shares. Dick’s and Harriet’s interests in TDH Advisors increase in value by $600,000 each, but they also enjoy a basis increase of $600,000.

Suppose, instead, that TDH Advisors and its shareholders have a redemption agreement that requires the company to buy back Tom’s shares for $1.2 million, funded by a $1.2 million life insurance policy. Even though the company, rather than the shareholders, buys Tom’s shares, Dick and Harriet each become 50% owners, so the value of their shares increases by $600,000 each. The basis of each shareholder (including Tom) is increased pro rata by the $1.2 million in life insurance proceeds collected by the S corporation. Thus, Dick’s and Harriet’s bases both increase by $400,000. Tom’s basis also increases by $400,000, but that increase is wasted because Tom’s estate receives a stepped-up basis equal to the fair market value of his shares.

Setting the price

Your buy-sell agreement’s terms for valuing the company’s shares and setting the purchase price are critical. Generally, the most effective method is to conduct regular, independent appraisals of the business, but a well-designed valuation formula can be an effective low-cost alternative. If you use the formula approach, however, there’s a risk the IRS will find that the business is undervalued, creating unexpected estate tax liabilities, interest and penalties.

Funding options

There are three basic methods of funding a buy-sell agreement:

1. Savings plan. The company or its owners simply save enough money to cover their obligations under the agreement. The problem with this approach is that funds may not be available if an owner dies or leaves the business sooner than expected or if savings are needed for unforeseen expenses. It also can cause AET problems for a C corporation.

2. Bank loans. When an owner dies or leaves the business, the company or the remaining owners borrow the money needed to fund the buyout.

But this approach can fall short if the company or its owners run into financial difficulty and have trouble obtaining a loan.

3. Life insurance. In most cases, life insurance is the most cost-effective method of funding a death buyout under a buy-sell agreement. It ensures that the funds will be available when needed. In addition, the insurance proceeds are generally tax-free (but watch out for AMT issues raised by C corporation redemption agreements).

Complex planning issues

Developing a buy-sell agreement that’s right for your business requires consideration of a number of complex tax and business planning issues. Thus, it’s wise to consult legal, tax and financial advisors to design an agreement and funding mechanism that meets your needs.

Sidebar: FTD delivers cost savings

For many businesses, first-to-die (FTD) life insurance offers a lower-cost alternative to
traditional insurance for funding a buy-sell agreement. In a typical buy-sell arrangement, individual life insurance policies are purchased for each owner. Alternatively, an FTD insures two or more lives simultaneously and pays a death benefit on the death of the first insured to die.

The primary advantage of FTD insurance is lower premiums: An FTD policy covering two people typically costs 25% to 30% less than two individual policies. But even though FTD insurance is an effective alternative for a redemption agreement, it can present some tricky tax and planning issues for cross-purchase agreements.

Joint ownership of an FTD policy used to fund a cross-purchase agreement may cause the insurance proceeds to be included in the deceased owner’s taxable estate and may also have negative income tax consequences. Many experts believe this result can be avoided if the buy-sell agreement requires the proceeds to be used to purchase the deceased owner’s interest or if the FTD policy is owned by a properly designed trust. The problem is that there’s little guidance on this issue and it’s difficult to predict how the IRS or the courts will treat such an arrangement.