After you have a valuable financial interest in your company, you may want to think about various exit strategies. A funded buy-sell agreement with your co-owner or partners can provide security to you, your partners and your family. A buy-sell agreement is a legal contract that is common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. When carefully drafted, your buy-sell agreement may be used to set the taxable value of your business interest.
The buy-sell agreement provides a measure of security for both parties of the sale. The buyer is bound by contract to buy your interest, and the buyer knows that you are not allowed to sell to another party. In addition, the buy-sell agreement identifies the conditions under which a sale will occur. You can choose the events that will trigger the sale of your interest under the agreement. Typical trigger events include death, long-term disability, retirement, and divorce.
With a buy-sell agreement in place, your family is relieved of any potential worries about what to do with your business interest if you should become sick, disabled, or die. Your plans for the business will have already been established and the pricing and financing terms agreed to in writing. Your family won’t have to search for a buyer or be at a negotiating disadvantage when they find one.
Typically, life insurance is used to fund a buy-sell agreement. When life insurance is used, either the company or the individual co-owners buy life insurance policies on the lives of each co-owner. If you were to die, the policy owners (the company or co-owners) receive the death benefits from the policies on your life. That money is paid to your surviving family members as payment for your interest in the business. Besides the death benefit, if sufficient cash values have built up within the policy, the funds can be accessed to purchase your business interest following your retirement or disability.
There are three types of buy-sell agreements. In an entity buy-out, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business is the owner and beneficiary of the policies. In a cross purchase buy-sell agreement, each co-owner buys a life insurance policy on each of the other co-owners. Each co-owner usually pays the annual premiums on the policies they own and are the beneficiaries of the policies. If there are many co-owners, multiple policies must be purchased for each co-owner. The third type of buy-sell agreement is a hybrid agreement that combines features from both the entity purchase and cross purchase models.
Life insurance creates a lump sum of cash to fund the agreement at death and the proceeds are usually paid quickly, ensuring that the buy-sell transaction can be settled quickly. While life insurance proceeds are generally income tax free, a C corporation may be subject to the alternative minimum tax (AMT).
Buy-sell agreements can be set up for companies with one or many owners. Just as there are different business ownership arrangements, there are different forms of buy-sell agreements. The buyer could be any or all of the current co-owners, an outside third party, or the business entity itself. While there are many advantages to setting up a buy-sell agreement, there are also disadvantages. One such disadvantage is that the agreement typically limits your freedom to sell the business to outside parties.
Contact your Coldstream Relationship Manager to discuss the pros and cons of a buy-sell agreement if you think that such an agreement is right for your business.