PROTECTING WHAT YOU'VE BUILT
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 may also restrict your ability to transfer your ownership 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 means such as life insurance, disability insurance, or cash borrowings.
1THE 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 departing owner’s interest 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.
Generally, when the business owner passes, their 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.
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.
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.
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.
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.
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.
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.
2CROSS-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.
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.
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.
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.
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.
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.
3THE 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.
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.
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.
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.
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.
ENSURE STABILITY IN YOUR BUSINESS WITH BUY-SELL AGREEMENTS
If you want to 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 select the best option and answer any questions you might have.
