A properly structured agreement can guarantee a buyer for your business interest, establish the taxable value of the business, create liquidity for estate taxes, improve the creditworthiness of the business, and help maintain the business’s legal status.
Although a buy-sell agreement has many benefits, it also may place restrictions on your ability to transfer your interest to parties outside of the agreement or leverage your business interest as collateral for outside credit. You’ll also want to be sure that your buy-sell agreement is properly funded by a means such as life insurance, disability insurance, or cash borrowings.
3 Main Types of Buy-Sell Agreements
There are several variations of buy-sell agreements. So you can better understand the differences in each option available, we’ll compare three of the main types.
1) The entity-purchase agreement
An entity-purchase agreement is a buy-sell agreement between the business itself and the owners of the business. Upon a triggering event (e.g., an owner’s death, disability, termination of employment), the business agrees to purchase the interest of the departing owner at an agreed-upon price. Insurance is a typical source of funding for this type of agreement. In the case of insurance funding, the business purchases insurance for each of the owners and becomes both the owner and beneficiary of the policies. The business then uses the proceeds from the policy to purchase the business interest from the departing owner’s (Owner A’s) estate.
- What type of business is this best suited for? This agreement is most appropriate for closely held businesses that are organized as a partnership, C corporation, S corporation, limited liability company (LLC), or professional corporation and is most useful for companies with a large group of owners, as the company funds the agreement. This agreement cannot be used for a corporation with only one stockholder nor for a sole proprietorship.
- What are the benefits of this type of buy-sell agreement? This type of agreement can be easier to fund than other types of agreements as the money comes from the business, not the shareholders. Closely held businesses tend to reinvest their earnings, increasing business assets but leaving less personal cash for the owners to make the stock purchase themselves. If the company decides to use insurance as funding, this type of plan requires the business to purchase only one policy for each owner.
- What are the potential downsides of this type of agreement? Insurance used to fund the agreement may be subject to claims by the company’s creditors. If family members are also shareholders, the favorable tax treatment can be eliminated by the IRS’s family attribution rules.
- What are the tax consequences for this type of agreement? When the business redeems the shares of the owner, it is not a tax-deductible expense for the business. When the cash is distributed in exchange for the stock, the business recognizes no gain or loss on the transaction. Also, when a corporation other than an S corporation partially redeems the stock of a shareholder, it may be treated as a dividend.
Generally, when the business owner passes, his or her estate receives a step-up in basis of business interest equal to the fair market value (FMV) of the interest at the date of death. If the sale price under the entity-purchase plan is the FMV, no capital gain or loss will be realized by the owner’s estate at the sale of the business interest.
For example: Assume Owner A paid $100,000 for her share of the business. She dies when the FMV of her interest is $200,000, and her estate then sells her business interest to the remaining owner for $200,000. The basis of her interest is stepped up from the original $100,000 to the FMV of $200,000 upon her death; at a sale price of $200,000, her estate does not recognize any capital gain.
When the corporation buys out the interest of an owner, however, the remaining owners do not receive an increase in basis for income tax purposes. If the stock appreciates, this will result in a larger capital gain when the remaining owners sell their interest.
For example: Owner A and Owner B each have a basis of $100,000 in their company. If Owner A dies, triggering the entity-purchase agreement, Owner B’s basis in the stock will still be $100,000. If Owner B later sells his interest for an FMV of $150,000, he will realize gains on $50,000. This is contrary to a cross-purchase agreement where the purchase price Owner B pays for Owner A’s stock would be an addition to his basis.
2) Cross-purchase agreement
A cross-purchase agreement is a buy-sell agreement between business owners in which any remaining owners must purchase the departing owner’s interest at an agreed-upon price if a triggering event occurs. Typically, each owner funds an agreement with each of the other owners.
- What type of business is this best suited for? As each owner would need to fund an agreement for each of the other owners, a cross-purchase agreement is most useful for companies with a small group of owners. This agreement is most appropriate for closely held businesses that are organized as a partnership, C corporation, S corporation, LLC, or professional corporation. This agreement cannot be used for a corporation with only one stockholder or for a sole proprietorship.
- What are the benefits of this type of agreement? Generally, when a corporation distributes money to a shareholder, it is considered a dividend payment. With a cross-purchase plan, however, the business owners are the parties to the sale, and no company money is used; therefore, the transaction is not considered a dividend. This type of agreement also avoids application of the attribution rules for the same reason.
- What are the potential downsides of this type of agreement? This type of agreement can be difficult to manage with more than four business owners due to how the agreement is structured—there may be dozens of contracts to fund and manage. When there is a triggering event, several transactions may be required to complete the purchase.
- What are the tax considerations for this type of agreement? Generally, when the business owner passes, his or her estate receives a step-up in basis equal to the FMV of the business interest at the date of death. If the sale price under the cross-purchase plan is the FMV, no capital gain or loss will be realized by the owner’s estate at the sale of the business interest.
When the co-owners buy Owner A’s business interest under the cross-purchase agreement, the price they pay for the departing owner’s interest is a contribution to basis. This leads to a reduced capital gain if the stock is later sold.
3) The wait-and-see agreement
A wait-and-see agreement is a hybrid between an entity-purchase agreement and a cross-purchase agreement. With wait-and-see buy-sell agreements, the buyer of the business interest is not identified in the agreement. The buyer could be the entity, the other owners, or both. The purchasers and the amount each will purchase are not determined until after the triggering event. Typically, the company has the first option to buy the departing owner’s (Owner A’s) shares. If the company fails to purchase the shares, the option to purchase the shares falls to the remaining owners. Finally, if the remaining owners do not purchase all the shares, the company is obligated to purchase all remaining shares. If properly structured, this agreement will guarantee that the business interest is sold to at least one potential buyer.
- What type of business is this best suited for? This agreement is most appropriate for closely held businesses that are organized as a partnership, C corporation, S corporation, LLC, or professional corporation. This agreement cannot be used for a corporation with only one stockholder or for a sole proprietorship.
- What are the benefits of this type of agreement? This plan offers flexibility by allowing for purchase by the business, individuals, or a combination of the two. As tax laws and personal and business circumstances often change, this type of agreement is beneficial because it is executed at the time of the triggering event, when financial conditions and current tax laws can be evaluated.
- What are the potential downsides of this type of agreement? Because the buyer is unknown at the time of the agreement, this type of agreement can be difficult to fund. The owners could purchase insurance policies on each other, and the policy proceeds could be used by the remaining owners or loaned to the business for it to make the purchase. Alternatively, if the business owned policies on the owners, the business could loan the proceeds to the owners to make the purchase, or the company could use the proceeds to buy the stock. Depending on how the plan is executed upon the triggering event, it could have the same downsides as those of an entity-purchase agreement, a cross-purchase agreement, or both.
- What are the tax considerations for this type of agreement? The tax considerations of a wait-and-see agreement depend on how the plan is executed upon the triggering event. It could have the same consequences as those of an entity-purchase agreement, a cross-purchase agreement, or both.
Ensure stability in your business with Buy-Sell Agreements
If you want to help ensure that your business survives beyond your ownership, be sure to choose the right buy-sell agreement for your situation. Your advisor can help you with selecting the best option for your situation and answer any questions you might have.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.