When a business owner dies, the disposition of his or her business interest can become a two-edged sword, creating problems for the business owner’s heirs as well as the business itself. Critical questions must be answered:
- Who will purchase the business interest?
- What is a fair price?
- When will the sale be made?
- Where will the funds come from?
A buy-sell agreement is a legal agreement in which the owner agrees to sell and some other person (meaning an individual or business entity) agrees to buy an ownership interest in a business. The buy-sell agreement should be drafted in consultation with legal counsel and tax advisors. A properly drafted buy-sell agreement can serve several purposes for the business. It:
- Creates a market for the business.
- Minimizes the possibility that the business might fall into the hands of outsiders.
- Minimizes the possibility that the parties involved will not be able to agree on a proper value for the business, and puts everyone on equal footing while all the parties are alive.
- Can, through insurance, ensure that funds will be available to make the purchase of the ownership shares.
- Provides a deceased owner’s estate with needed liquidity by converting an illiquid asset into cash.
- Provides for the orderly transfer of the ownership of the business.
- Can establish the value of the business for estate tax purposes.
Types of Buy-Sell Agreements
Entity Buy-Sell Agreements
Under an entity or stock redemption agreement, the business agrees to purchase a deceased owner’s interest. To help fund the agreement, the business purchases life insurance on the life of each of the owners; the business owns the policies and is the beneficiary of each policy. The face amount of each policy approximates the purchase price for the insured’s business interest.
Cross-Purchase Buy-Sell Agreements
Another type of buy-sell agreement is a cross-purchase buy-sell agreement. Under a cross- purchase agreement, the surviving owners (rather than the business itself) agree to buy the deceased owner’s interest. This arrangement is usually memorialized in a written agreement among the owners.
Wait-and-See Buy-Sell Agreements
The wait-and-see buy-sell agreement is a buy-sell agreement that combines aspects of the entity purchase buy-sell agreement and the cross-purchase buy-sell agreement. Often called a “hybrid” buy-sell agreement, it is unlike the traditional entity buy-sell and cross-purchase agreements, because the specific purchaser of an owner’s business interest remains uncertain until the triggering event actually occurs. In a wait-and-see buy-sell agreement, the business entity has the first chance to purchase the owner’s interest, then the other owners may purchase the interest, and following the purchase period of the other owners, finally, the business entity is required to purchase the ownership interest.
The Life Insurance Advantage
As long as premiums are paid when due and there have not been significant loans or withdrawals, the business may have funds to help purchase a deceased owner’s business interest. By contrast, building an investment or reserve fund takes time. If an owner dies “too soon,” the business may not have the funds it needs to purchase the deceased owner’s business interest.