An Overview of Buy-Sell Agreements
Depending on the size of a business, the purposes and uses of a buy-sell agreement can be very different; however the goal is the same in any case – to avoid the unplanned, such as when circumstances change unexpectedly, and create as smooth an ownership transition as possible. Simply stated, a buy-sell agreement is a binding agreement that sets forth the terms under which one or more current owners will purchase a departing or exiting owner’s share of the business.
There are four business entity types common to private company ownership: sole proprietorship, LLC, partnership and corporation. Each business entity type has its own buy-sell agreement structure and approach. For example, an LLC or partnership will likely use one of two approaches: purchase by right of first refusal or purchase by mandatory purchase obligation (the purchase by mandatory purchase obligation is generally more complex). In the case of a corporation, the buy-sell agreement must be structured to comply with the restrictions found under the Internal Revenue Code.
In the event an existing owner becomes deceased, disabled, opts to retire, wishes to divest their ownership interest (by sale or gift), or otherwise desires a change in status, there is a need for an ownership transition plan. Through the use of a buy-sell agreement and a properly funded common approach, a smooth ownership transition can be created.
Buy-sell agreements are often treated as separate agreements, but the agreement can be a part of the operating agreement of the business . A buy-sell agreement can also often be incorporated into a pre-existing shareholder or partnership agreement, or be entered into separately from these agreements.
The buy-sell agreement incorporates the fundamental agreement of the parties regarding a change in ownership. The agreement can set forth the purchase terms for an existing owner’s disqualification (due to the owners death, disability, voluntary retirement, involuntary retirement, sale of shares, termination of employment, bankruptcy, etc.). Often incorporated into the buy-sell agreement is an insurance arrangement that provides the funds needed to pay the purchasing parties their respective pro rata portion of the selling or terminating owners interest in the business. These contractual arrangements can be found in buy-sell agreements within the corporate context in the form of a "cross purchase" agreement (which is a two-party agreement), or in the form of an "entity purchase" agreement (which is a three-party agreement). The appropriate circumstances may also provide for the use of multi-party buyout arrangements.
Buy-sell agreements which incorporate an insurance policy funding arrangement, therefore, operate both as a contract and an insurance arrangement. The life insurance policy is acquired on the life of the owner and, as long as the agreement is properly structured, the proceeds are available to purchase a death benefit attributable to a decedent shareholder.
The Role of Life Insurance in Buy-Sell Agreements
Whether the buy-sell agreement is funded by life insurance or not, it is the insurance that gives the agreement its power. In the event of death, the insurance proceeds mean the surviving owners can buy out the interest of the deceased’s estate, even if there are not sufficient funds in the business. If the purchase price is not funded with insurance, the remaining owners or the company must find the money somewhere else. Life insurance provides a greater guarantee of liquidity of the business interest than can be achieved through any other means.
Cross-Purchase Plan
In a cross-purchase plan, each owner enters into a separate agreement with each other owner to buy his or her shares. At the death of an owner, the company purchases the shares of the decedent’s estate from the other owners. In many cases, the cross-purchase plan is the first alternative to be considered by the owners, because each owner can directly control his or her own beneficiary designations, and it is often simpler to set up.
Entity Purchase Plan
In an entity purchase plan, the deceased’s estate sells his or her shares to the corporation or limited liability company (LLC), which immediately redeems the shares. A key advantage of an entity purchase plan is that the agreement makes no direct reference to the stockholders or owners, and the purchase is accomplished according to the agreement with no other consent being required. The agreement commits the business entity to purchase the shares of the deceased from delegated representatives, according to the terms of the agreement, without regard to the wishes of the deceased’s estate or family members.
A business purchaser (and its owners) will want the equity in the business to be illiquid, because if the purchased stock could be liquidated other than by redemptions, the value of the deceased owners’ or partners’ interest could be reduced to the detriment of the business purchaser and its continuing owners. For this reason, the buy-sell agreement should be drafted to remove any ability of the deceased’s estate or family to redeem, recapitalize, or otherwise cause liquidity to be achieved by any means other than the payment of the purchase price over time pursuant to the buy-sell agreement.
The Tax Advantages of Using Life Insurance in a Buy-Sell Agreement
One of the major benefits of using life insurance to fund a buy-sell agreement is the tax advantages. For example, the death proceeds of a life insurance policy are received by the company income tax free. The cost of insurance may be deductible as an expense of the business.
Another advantage of permanent life insurance is that the cash value of a permanent life insurance policy grows on a tax deferred basis. This allows the business owner to retain or accumulate the cash value as tax deferred savings for future business needs, whether as collateral for a future loan or to provide liquidity for a corporation in the sale to a third party.
Common Tax Issues to Consider
The issues discussed above raise a common question regarding the tax treatment of premiums paid under a life policy in a buy-sell agreement. Section 264(a)(1) of the Internal Revenue Code of 1986, as amended (the "Code") prohibits the deduction of premium payments by a corporation for policies indirectly owned by the corporation if the insured is an officer, director, or employee of the corporation and is directly or indirectly either the direct or indirect beneficiary of such policies.
For this reason, some buy-sell agreements provide for the use of insurance trusts. A typical situation is a business in which one owner wishes to leave that interest to his children and the other owners do not. The death benefit proceeds payable under an insurance policy on the life of the first to die could be used to purchase the shareholder’s stock out of the decedent’s estate with resources from the trust established by the shareholders. Section 264(a)(2) clarifies that the rules of Section 264(a)(1) do not apply to the trust so long as no part of the policy differs from the typical policy. This means that the premium payments by the trust may be claimed as a deduction where the policy is owned by a trust as long as Section 264 does not apply. The Section 264 exception also applies to insurance owned by a third party other than the business owners or the trust, so long as Section 264 does not otherwise apply.
Section 264 also applies to prohibit the deduction of premiums when a corporation is the beneficiary of policies owned by key employees insuring the life of another key employee if the corporation enters into an arrangement with respect to the policies that would allow the corporation to receive the proceeds under the policies.
As the above discussion demonstrates, structuring a plan to purchase the business from an owner’s estate can be complicated for the business owner and involves many factors, including tax and other property law aspects of business planning.
Potential Tax Pitfalls in Buy-Sell Agreements
Tax Pitfalls – Mistakes to Avoid and Ways to Avoid Them
These are the traps that seem to come up from time to time when structuring a buy-sell agreement for business owners.
One partner wants to have their family excluded as beneficiaries of policies. That may sound good, until the client is forced to deal with a potential taxable gift (and a further possible estate tax) event when the buyout is triggered.
A business entity may not be the preferred owner. This will certainly produce a taxable event for the decedent’s estate. If a business entity is the owner, funding options must be carefully examined to avoid undesirable outcomes. Often, needlessly costly insurance policies are recommended for this structure, which results in more insurance premium outlay than is necessary .
Too often, formulas are used to calculate the purchase price or payment of the death benefit proceeds as opposed to ongoing valuations. Either way, the result for one party can be misunderstood. One business owner may believe they are getting a fair price for their interest (but do not realize they will have to pay capital gains tax on the difference). The surviving partner believes they got a fair value for the business interest but may have to pay more than market value for it if the value was not updated within the buyout terms (or if the value was significantly higher). Either way, the indemnification of the purchase price amount could increase the tax burden on the surviving partner.
Scrivener error – drafting the policy to include future purchases or acquisitions. You cannot "acquire" insurance on a life that is deceased.
Consulting Your Tax Advisor
Given the complexities involved in tax implications surrounding life insurance products, businesses cannot afford to overlook engaging the services of tax professionals and legal advisors. The input of a tax professional is crucial in analyzing the impact of the buy-sell agreement on the overall business owner tax strategy. This strategy should include: The tax professional should also identify and consider the tax implications for each individual under the buy-sell agreement terms. The integrated tax strategy should then be discussed with the legal counsel creating the documentation to ensure there are no inconsistencies. The business owner should, at a minimum, meet annually with their financial advisor, tax advisor, and legal counsel to review and update their integrated tax strategy to reflect changes in facts or the tax laws.
Buy-Sell Agreements and Life Insurance: Conclusion and Summary Points
The use of life insurance to fund buy-sell agreements between shareholders or partners can be an effective tool in the right circumstances to address the issues arising on a partner’s or shareholder’s death. Whether a buy-sell agreement is entered into and funded by life insurance or other means, the agreement must be carefully drafted and reviewed to ensure that its provisions do not create a financial windfall to the continuing shareholders or partners and that the share valuation provisions do not result in a deemed dividend on death. The terms used by the partnership agreement and contemplated in a shareholders agreement must be consistent with the terms of the insurance policy funding the buy-sell agreement or the proceeds could end up in the hands of the insurance company instead of the beneficiaries . Accordingly, the shareholders or partners should ensure that the buy-sell provisions of the insurance policy and the terms of the buy-sell agreement align with each other and also with the underlying partnership or shareholders agreement. Tax considerations must be taken into account in structuring the buy-sell agreement, the insurance contract and the corporation or partnership to avoid or minimize unwanted tax consequences, and consideration must be given to the possibility of future tax changes that may impact the structure or the tax liability resulting from a triggering event. Consulting with a qualified tax advisor is essential to determine the options available to minimize tax liabilities.