02 Aug Buying a Business with Co-Owners? You Need a Buy-Sell Agreement!
If you are buying a business with one or more co-owners, please take our advice and set up a buy-sell agreement. A well-drafted agreement can do these valuable things for you:
1.Transform your business ownership interest into a more liquid asset
2.Prevent unwanted ownership changes
3.Save taxes and avoid hassles with the IRS
Read this article to find out how buy-sell agreements work and the important details to understand. Then huddle with your co-owners, attorney, and tax pro to hash out a buy-sell agreement that suits your situation.
Buy-Sell Agreement Basics
Buy-sell agreements come in two basic flavors:
- Cross-purchase agreements
- Redemption agreements (sometimes called liquidation agreements)
When you enter into a cross-purchase agreement, it’s a contract between you and the other co-owners. Under the agreement, a withdrawing co-owner’s ownership interest must be purchased by the remaining co-owners when a triggering event occurs, such as death or disability.
When you enter into a redemption agreement, it’s a contract between the business entity itself and its co-owners (including you). Under the agreement, a withdrawing co-owner’s ownership interest must be purchased by the entity when a triggering event occurs.
Both types of agreements have three main goals.
Goal No. 1. Ensure that there will be a willing buyer for each co-owner’s interest when a triggering event occurs.
Goal No. 2. Restrict each co-owner from unilaterally transferring his ownership interest to someone outside the existing group.
Goal No. 3. Ensure favorable tax results for all concerned.
You and the other co-owners specify the triggering events you want to include in your buy-sell document. You’ll certainly want to include obvious events like death, disability, and attainment of a stated retirement age.
You can also include other triggering events that you deem appropriate—such as loss of license to practice a profession, bankruptcy, or the simple desire to cash out of the business and move on.
Valuation and Payment Terms
Make sure your buy-sell deal stipulates an acceptable method for valuing the business ownership interests.
Common valuation methods include a fixed per-share price, using an appraised fair market value figure, or following a formula that sets the selling price as a multiple of earnings or cash flow. As explained later, you’ll want to make very sure that your price-setting method will be respected by the IRS for federal estate tax valuation purposes.
Also make sure the agreement specifies how amounts will be paid out to withdrawing co-owners or their heirs under various triggering events.
Most buy-sell agreements grant the remaining co-owners (in the case of a cross-purchase agreement) or the business entity itself (in the case of a redemption agreement) a right of first refusal to purchase the withdrawing (or deceased) co-owner’s interest. If that right is not exercised, the withdrawing co-owner (or his or her heirs) can sell to an outside party without any further need for permission from the remaining co-owners.
Bottom line. By putting a buy-sell agreement in place, you get a guaranteed market for each withdrawing co-owner’s interest coupled with control over who is allowed to join your ownership group. As you can clearly see, this is a beneficial arrangement for you—whether you turn out to be the first co-owner to withdraw or the last owner standing.
Use Life Insurance to Fund Your Buy-Sell Agreement
Obviously, you’ll need cash to finance buyouts of withdrawing co-owners when triggering events occur under your buy-sell agreement.
The death of a co-owner is the most common, and most catastrophic, type of triggering event. You can use life insurance policies to form the financial backbone of your buy-sell deal. Here’s how. In the simplest case of a cross-purchase agreement between two co-owners, have each co-owner purchase a life insurance policy on the other.
When one co-owner dies, the surviving co-owner collects the life insurance death benefit proceeds and uses the cash to buy out the deceased co-owner’s interest from the estate, surviving spouse, or other heir. Tax-wise this cross-purchase arrangement works great.
The life insurance death benefit proceeds are totally free of any federal income tax, as long as the surviving co-owner was the original purchaser of the policy on the other now-deceased co-owner.1
Warning. When attempting to fund a simple cross-purchase agreement, don’t swap your existing policy on your own life for another co-owner’s policy on his own life. Also, don’t designate a co-owner as the new beneficiary of your existing policy on your own life. If you do either of these things, it can turn the life insurance death benefit proceeds from 100 percent tax-free into 100 percent taxable under the dreaded “transfer for value” rule.2 That would be a tax disaster!
When possible, have each co-owner buy a new policy on the life of each other co-owner. That way, you avoid the transfer for value problem and lock in federal-income-tax-free treatment for all life insurance death benefit proceeds received under your cross-purchase agreement.
Using existing policies. If you must use existing policies to fund your cross-purchase deal (say, because one or more of the co-owners are now uninsurable), you have several ways to avoid the transfer for value problem. For instance, you may be able to transfer existing policies into a trust or a partnership owned by you and the other co-owners. When one co-owner dies, the trust or partnership distributes the life insurance death benefit proceeds tax-free to the remaining co-owners, who then use the cash to buy out the deceased co-owner’s share of the business.
More than two co-owners. A seemingly simple cross-purchase arrangement between more than two co-owners can get complicated in a hurry. Why? Because each co-owner must buy life insurance policies on all the other co-owners.
In this scenario too, you may want to use a trust or partnership to buy and maintain one policy on each co-owner. Then if a co-owner dies, the trust or partnership collects the death benefit proceeds tax-free and distributes the cash to the remaining co-owners, who use the money to fund their buyout obligations under the cross-purchase agreement. Using a trust or partnership also makes it much easier to ensure that all the life insurance premiums get paid.
Redemption. To fund a redemption buy-sell agreement, the business entity itself buys policies on the lives of all the co-owners and then uses the death benefit proceeds to buy out the deceased co-owners. Regardless of whether the entity purchases new policies or the co-owners transfer existing policies on their own lives to the entity, there is generally no transfer for value problem. So, the death benefit proceeds will be completely free of any federal income tax.3
No Life Insurance
Specify in your agreement that any buyout that is not funded with life insurance death benefit proceeds will be paid out under a multiyear installment payment arrangement. This gives you (and any other remaining co-owners) some much-needed breathing room to come up with the cash needed to fulfill your buyout obligation.
Create Certainty for Your Heirs
If you are like most small-business co-owners, the value of your share of the business is a big percentage of your estate. Your heirs face two big potential problems without a buy-sell agreement:
1.After your demise, there may be no market for your business ownership interest. Even worse, your heirs might be forced to sell just to pay estate taxes.
2.Your heirs may have to tangle with the IRS over valuing your share of the business for federal estate tax purposes.
Now for the good news: Installing a buy-sell agreement can cure these problems. Having an agreement in place ensures that your ownership interest can be sold under financial terms that you’ve already approved when you set up the agreement. Your estate’s liquidity problem is eliminated. Good!
Almost as important, the price set by a properly drafted buy-sell agreement will establish the value of your ownership interest for federal estate tax purposes. In other words, the price at which your estate sells the interest under the terms of the agreement can be used as the value for calculating the estate tax bill. Your heirs will thank you for keeping the IRS at bay!
Warning. The buy-sell agreement must set a reasonable price for your business ownership interest. Otherwise, the IRS can completely disregard the agreement.4
The absolute worst-case scenario occurs when the agreement sets an unrealistically low price that allows someone outside your family to buy your share of the business for less than it’s actually worth. Your heirs get stiffed.
To add insult to injury, the IRS still has the right to come in and assess federal estate tax on the higher price that should have been charged but wasn’t. So, your heirs can get stiffed again. This sounds incredibly unfair. It is incredibly unfair. But it has happened.5
Keep this from happening by adopting a buy-sell agreement that sets a reasonable price for your ownership interest.
As a co-owner of a valuable business, insist on having a well-drafted buy-sell agreement in place.
- The agreement provides financial protection to you and your heirs as well as to your co-owners and their heirs.
- The agreement also will help minimize income taxes and avoid hassles with the IRS over estate taxes. (See the tax-saving specifics below for more advice.)
- Buy-sell agreements are not suitable do-it-yourself projects. Get legal and tax advice from professionals experienced in setting up buy-sell arrangements.
- Don’t wait to get your buy-sell agreement up and running. The clock is ticking, and you never know when your time has run out.