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In the wake of the nearly unprecedented economic downturn caused by the COVID-19 pandemic, businesses have been scrambling to stay solvent — let alone, profitable. Business owners may want to consider implementing any available strategies that will help reduce risk going forward. One such strategy is a buy-sell agreement, which can protect businesses and maintain stability in the event that ownership interests need to be transferred.
What is it?
In a nutshell, a buy-sell agreement is a contract among a business’s owners that sets guidelines for the transfer of their ownership interests. The agreement gives the remaining owners (or the business itself) the right — or, in some cases, the responsibility — to buy an exiting owner’s interest if a “triggering” event occurs. A triggering event may include an owner’s divorce, disability, retirement, desire to leave the company, death, or loss of a professional license or certification.
So, the agreement creates a market for a withdrawing owner’s interest. Additionally, by outlining when and to whom interests can be sold, it can help avoid conflicts among remaining owners or with the withdrawing owner’s family.
A buy-sell agreement also addresses how the price of the interest will be determined, including defining the valuation method and standard of value to be used.
How can you fund it?
When a triggering event occurs, a substantial amount of money likely will be needed to buy the departing owner’s interests. Properly funding a buy-sell agreement helps to ensure that money will be available to cover the purchase.
A popular funding means is life insurance. Even though life insurance might be thought of primarily as a means to provide liquidity on the death of one of the owners, it’s not limited to such situations.
Using life insurance to fund the buy-sell is beneficial because it can ensure that the departing owner or his or her beneficiaries will receive the agreed-upon price for the business interests in a timely manner. It also can ease the strain on your company’s cash flow or reduce the chance that you’ll have to sell off assets to pay the bill resulting from a buyout.
One option is a cross-purchase agreement, where each owner takes out a life insurance policy on each of the other owners. For example, let’s say you buy an insurance policy on your business partner. When he or she dies, triggering the buy-sell agreement, you’ll collect the death benefit and use it to buy his or her partnership interest from the estate.
Owning the policy (assuming it’s large enough) guarantees you’ll have the money needed to fulfill your obligations under the agreement. Other benefits are that the insurance proceeds won’t be taxable (as long as you plan properly), and that your tax basis in your newly acquired interests will be equal to the purchase price.
But a cross-purchase agreement can be cumbersome if there are more than a few owners because of the number of policies required. It also can be unfair if there’s a significant disparity in owners’ ages or health, causing the policy premiums to vary substantially.
One alternative is establishing a trust or a separate partnership to buy a policy on each owner. When one of you dies, the trust or partnership collects the death benefits on behalf of each owner. You then use your portion from the trust or partnership to pay your share under the buy-sell agreement.
Another alternative is a redemption agreement. It requires a withdrawing owner to give the business entity the first right of refusal if he or she wants to sell the interest to a nonowner. The life insurance is purchased by the business, rather than the owners, so only one policy on each owner’s life is required. The policy proceeds will be tax-free to the business.
A disadvantage of a redemption agreement is that the remaining owners won’t receive a step-up in basis when the company purchases the deceased owner’s interest. This can result in higher capital gains taxes when they sell their interests.
Tried and true
A buy-sell agreement isn’t a new strategy — but it’s a tried-and-true method that can help keep your business operations stable during any potential transitions of ownership. Even if you already have one in place, it’s a good idea to review it in light of current conditions to ensure it will cover all possible contingencies.