BUY-SELL AGREEMENTS: PROTECTING YOUR FAMILY’S FUTURE

When Marie Archer was diagnosed with a serious medical condition, the scare to her family and business associates extended beyond the expected concern for her health. Marie owns a small software design firm she built from scratch with her business partner Jeff Page. The company’s success has always allowed Marie’s family to live comfortably. Though Marie’s illness is no longer considered life threatening, suppose she had died prematurely. What would have happened to her interest in the business? Would Jeff have had access to a ready source of cash to buy out Marie’s share of the company? If so, what price would he have paid? And, most importantly, where would such a tragedy have left the financial future of Marie’s family?

Caught up in the ongoing rush of day-to-day business activity, the two partners had never found time to address these questions. Fortunately, Marie’s medical condition was caught early and she has an excellent prognosis for recovery. But, the thought of what “might have been” has served as a wake up call for both Marie and Jeff and their families.

Types of Agreements

How does a business owner plan for this type of situation? Generally, with a buy-sell agreement funded with life insurance. A buy-sell agreement is a legal contract that establishes a buyer for an owner’s share of a business and stipulates the price to be paid. Buy-sell agreements are typically negotiated with partners, shareholders, members of the management team, or key employees who have an interest in a company’s future ownership. A life insurance policy on the owner’s life usually funds the deal.

Two commonly used types of buy-sell agreements are cross-purchase agreements and entity purchase agreements. A cross-purchase agreement is negotiated between a business owner and each partner or shareholder. If one party dies, the survivors purchase the deceased’s shares at a previously agreed upon price with life insurance funding the purchase. A cross-purchase agreement works best in companies with only two or three owners. As the number of owners increases, it can become expensive and administratively cumbersome for each owner to have a life insurance policy and  cross-purchase agreement on every other owner.

For a company with a larger number of owners, an entity purchase agreement may be more workable. An entity purchase agreement is negotiated between the company and each shareholder. The company purchases a life insurance policy on each shareholder’s life. This serves to reduce the administrative overhead of managing multiple buy-sell agreements and life insurance policies—a difficulty inherent in cross-purchase agreements. However, it is important to note that since the company owns the life insurance policies, the accumulated cash value may be vulnerable to corporate creditors.

Tax Considerations

Apart from cost and administrative concerns, tax considerations also play an important role when deciding between a cross-purchase agreement and an entity purchase agreement. When an owner dies, one benefit of a cross-purchase agreement is that the surviving owner(s) receives a step-up in basis for the newly acquired shares. In other words, future capital gains on the new shares are based on the purchase price spelled out in the agreement, not on the deceased owner’s original basis. 

In contrast, an entity purchase agreement does not carry this advantage. Since the company purchases the shares of a deceased owner, the remaining shares of each surviving shareholder increase in value. Which type of arrangement is best in a given situation? When deciding this, a company must weigh the potentially lower cost and administrative ease of an entity purchase agreement against the possible tax advantages of a cross-purchase agreement.

An Ounce of Prevention. . .

Unfortunately, we never know what tomorrow will bring. Business owners currently operating without buy-sell agreements in place should act now. If an unforeseen tragedy should occur, a buy-sell agreement help ensure that family members will benefit from the years of hard work spent building up a closely-held business. Since buy-sell agreements are complex, legal documents, it is best to consult qualified insurance, legal, and tax professionals to obtain appropriate insurance and tax guidance