There are many reasons why a business should create a buy-sell agreement. After all, you never know what may happen down the road. Your company might go through a change in ownership. Partners may choose to leave the business, die or become disabled. Such occurrences illustrate the need to have an ironclad agreement to ensure all partners are protected.
If you or one of your fellow owners leaves the company, the departing owner's business interests will probably need to be transferred. This is where a buy-sell agreement comes into play. It's a formal contract that estimates your company's value (or defines the valuation method to use) and outlines when and to whom the interests can be sold.
First and foremost, with a buy-sell agreement in place, you stand a better chance of preventing potential conflicts among remaining owners and with a deceased owner's family members. You can also preserve (or more smoothly transition) management control while creating a market for the sale of the withdrawing owner's business interest.
Besides stipulating the terms of any ownership change, a buy-sell agreement specifies how the transaction will be funded. Typical options include life insurance, loans, savings plans, installment purchases and sinking funds.
Of these choices, life insurance tends to be the most popular. This is because, among other reasons, it both ensures beneficiaries receive the agreed-upon price for the business shares in a timely manner and helps prevent a buyout from choking a company's cash flow. Of course, the full face value of the policy becomes funded only in the event of a death.
Generally, buy-sell agreements are structured in one of two ways. Under the first option, a cross-purchase agreement, the withdrawing owner sells his or her interest to some or all of the remaining owners. In the case of a death, the insurance proceeds (assuming life insurance is the funding method) won't be taxable and the surviving owners will be provided with a tax basis equal to the purchase price of their new shares.
On the downside, because each shareholder must own an insurance policy on each other shareholder's life, the number of policies can quickly become unwieldy. (This problem can be alleviated, however, by forming a partnership to own the policies.) Additionally, age or insurability can create a disparity in premiums, with younger or healthier owners incurring higher premiums to cover older or less-healthy owners.
The other option is a redemption agreement, under which a withdrawing owner's shares are redeemed by the business itself. If the agreement is funded with life insurance and there are many shareholders, a stock redemption agreement is easier to administer than a cross-purchase because only one policy on each shareholder's life is required. The company also can absorb premium differences associated with age or health disparities among shareholders.
One reason some business owners decide against a redemption agreement is that the remaining shareholders don't receive the benefit of a step-up in basis when the company purchases the deceased shareholder's interest. Rather, they retain their original basis in the company.
So, compared with a cross-purchase agreement, the redemption agreement can create greater potential capital gains if the business is subsequently sold. It also can create an unexpected alternative minimum tax (AMT) bite for a C corporation in the year life insurance proceeds are received.
On the bright side, by following a stock redemption, the corporate assets should be relatively unchanged. The insurance proceeds will be used to buy the deceased's interest, but each owner will have acquired a greater ownership percentage.