A buy-sell agreement, also known as a buy-out agreement, is a legally binding agreement between co-owners of a business. Such an agreement stipulates the rules of the situation if a co-owner dies or is forced out of the firm or chooses to leave the business of his/her own free will. In simple terms, it may be thought of as a sort of premarital agreement between business partners and is sometimes referred to as a “business will”.
The purpose is that the business can continue to operate with as little disruption as possible for the surviving business owner (s), as well as ensuring that the estate of the deceased business owner receives fair value for his/her business interests, as well as settlement of the credit loan account.
Where a business is held in a trust (or a corporate entity such as a company) the reality is that even though the trust or corporate entity can continue to hold the business interest in perpetuity, there is often only one of the trustees/shareholders who is directly involved in the business, who influences the success of the enterprise and upon whose death and thus, in all likelihood, the trust or entity would no longer wish to continue to hold its interest in the business, as it would not make commercial sense to do so.
Why it is important for the surviving business owners’ perspective to have a buy and sell arrangement in place.
1. The surviving business owners may want to buy the deceased’s interest in the business, but have to raise finance to do so. Therefore they will be paying interest on the finance raised which would mean that over time they will be paying more than the original purchase price of the business.
2. Should the surviving business owners not manage to raise finance to purchase, it could mean that the deceased’s spouse and/or dependents would become co-owners. They may not have the skills or expertise to be of value and would be a drain on the business.
3. If the deceased as co-owner had a credit loan account, this must be settled on his/her death and if there is insufficient liquidity in the enterprise, this could present a serious problem.
Implementing a business assurance arrangement
1. The business’s accountant or auditor should establish the value of the business.
2. If credit loan accounts are to be included in the buy and sell arrangement, these values should be determined.
3. In order to purchase the respective business interest in the business, life cove and/or disability cover is required.
4. To make a proposal in respect of the buy and sell arrangement the business owners, details of their marital regime must be established.
5. All the necessary documents to obtain life/disability cover must be completed in full at the Life office.
6. A formal buy and sell agreement must be drawn up and signed. It is critical that the parties do enter into the buy and sell agreement, as they need both of the signed agreements and life insurance in order to have a binding and effective buy and sell arrangement.
In an entity purchase buy-sell agreement, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and 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 your company has a large number of co-owners, multiple policies must be purchased by each co-owner. A wait and see (or hybrid) buy-sell agreement allows you to combine features from both the entity purchase and cross purchase models. The business can buy policies on each co-owner, the individual co-owners can buy policies on each other, or a mixture of both methods can be used.
The buy-sell agreement should be fully funded
The amount of insurance coverage on your life should equal the value of your ownership interest. Then when you die, there will be enough cash from the policy proceeds to pay your family or estate in full for your share of the business. But if all that is affordable is insurance coverage for a portion of your interest, you might want to go ahead and fund that amount. Later the company may be able to increase the amount of insurance or use additional funding methods. In the meantime, the agreement should specify how your family or estate will be paid.
The Value of the business could change overtime
What if the insurance proceeds turn out to be less than the value of your business interest, due to growth in the business? Your surviving family members might end up getting less than full value for your business interest. Your buy-sell agreement should specify how the valuation difference will be handled.
Conversely, the insurance proceeds might be greater than the value of your business interest when you die. Your buy-sell agreement should address this potential situation upfront and specify whether the excess funds will belong to the business, the surviving co-owners, or your family or estate.
Should Group Life Insurance be used?
Using a company’s group life insurance plan to fund a buy-sell agreement is generally not recommended. Normally, group life insurance premiums are tax-deductible to the company. But premiums are no longer deductible if the business is the beneficiary.
Possible negative tax consequences
For policies issued after August 16, 2006, the death benefits of life insurance on the life of an employee payable to the employer/policy owner may be subject to income taxes unless an exception applies.
Assume your business is a corporation or is taxed as one. When one of your co-owners dies, his or her estate becomes the owner of the insurance policies covering you and the other co-owners of the business in a cross purchase agreement.
If these policies are then transferred to the surviving co-owners to pay for future buyouts, a transfer-for-value (gain) may occur, and a portion of the proceeds received from the transferred policies may be taxable.
If a policy is cancelled (surrendered) for cash to buy out your interest while you are living, any gain on the policy is subject to federal income tax for the policy owner. Gain includes all policy loans outstanding at the time of surrender. Also, the policy may carry surrender charges.
Keeping track of your buy-sell agreement
Each year, the premiums on the policies must be paid, or the insurance will lapse. So monitor premium payments carefully. Your buy-sell agreement should include a feature requiring ongoing proof of payout . Also review the amount of insurance regularly. The insurance coverage may have to be increased periodically to reflect increases in the value of the business. Finally, periodically check the financial rating of your insurance company. The policies funding your buy-sell agreement will do your family no good if the insurer becomes insolvent.