Having a properly structured buy-sell agreement in place is a best practice for long-term business success. Also known as a buyout agreement, the right buy-sell plan provides vital financial protection for shareholders or partners and their families. It also helps to ensure the continuity of the business for employees and customers. Here are some tips to consider.
Common events that trigger a buy-sell scenario
Whether you have a mature business or a startup, the excitement and intense work that comes with running a business or getting a venture off the ground can often crowd out some of the “what if” considerations in the background. Many of these “what ifs” may not be fun to think about, but thoughtful planning can help minimize disruption from common lifecycle events that impact many companies sooner or later.
Some of these include:
- An owner or shareholder suddenly leaves the business
- An owner or shareholder becomes incapacitated or unable to fulfill their duties
- An owner or shareholder passes away
A buy-sell agreement is a contract —often funded by a life insurance policy — that gives the remaining interested parties the cash infusion they need to acquire the shares of the departing, disabled, or deceased party. Without the liquidity that an insurance policy provides, the remaining shareholders or family members might be forced to borrow funds under adverse terms to continue operations and meet other needs that arise from the triggering event.
The two main types of buy-sell agreements and how they work
There are two main ways to structure a buy-sell agreement. One is called a cross-purchase agreement and the other is called an equity purchase agreement (also known as a stock or membership interest redemption agreement).
In the cross-purchase form, each shareholder establishes a life insurance policy on every other shareholder so that each effectively functions as both a policy owner and a beneficiary. In an equity purchase, the business itself establishes a life insurance policy in the names of the shareholders and is the owner and beneficiary of the policy.
The proceeds from cross-purchase policies go to the remaining shareholders to buy out the shares of the departing, disabled, or deceased party. The proceeds from equity purchase policies go to the business, which in turn redeems the ownership of the named party. Portions of the benefit may also be designated to go to family members or dependents of the departing, disabled or deceased party.
The cross-purchase structure is good for companies with a few owners, but it can be impractical for large numbers of shareholders because it multiplies the number of policies you have to manage. Another disadvantage is that premiums can differ greatly depending on the ages of the shareholders, creating a financial imbalance.
The equity purchase structure eliminates premium disparities between parties because the premiums are paid by the business rather than by the insured individuals. On the other hand, the equity purchase structure opens up the potential for additional tax exposure unless very specific reporting and compliance conditions are met well in advance.
How and why to take a closer look at buy-sell agreements
The best time to set up a buy-sell or buyout agreement is early in the relationship when all the shareholders are alive and actively engaged in common goals for the business. However, it is also important to periodically revisit the agreement and the adequacy of the life insurance that has been put in place to fund them. These agreements are a proven and trusted way to protect co-owners, family members, employees and customers who depend on business continuity. Buyout agreements also address several uncertainties:
- Will the business pass into the hands of unqualified or hostile parties?
- Will ownership be contested by people who don’t have my best interests in mind?
- Will loved ones be left cash-strapped because of a departed shareholder?
- Will transfer of ownership be conducted in an ethical and orderly way?
- Will all interested parties be assured of fair market valuation?
- Will we be surprised by adverse income or estate tax issues?
If you have questions about a buy-sell agreement for your business, or currently have one in place but aren’t sure if it’s structured properly, Clayton & McKervey and Kapnick Insurance can help you explore your options. The more you know about the relative advantages and disadvantages of each structure for your specific business conditions, the better outcomes you can ensure for the people you care about. There may also be significant tax and estate planning benefits to gain.
Clayton & McKervey
Clayton & McKervey is a full-service CPA firm helping middle-market entrepreneurial companies compete in the global marketplace. The firm is headquartered in metro Detroit and services clients throughout the world. Visit claytonmckervey.com or contact us today to learn more.
Founded in 1946, Kapnick Insurance is an independent professional advisory firm with Michigan roots and a global reach. Their 170+ employees provide expert guidance pertaining to business insurance, risk solutions, employee benefits, worksite well-being, and personal insurance to a vast and diverse base of clients worldwide. For over 75 years companies have looked to Kapnick as a trusted advisor, providing solutions that protect their operations and employees. Visit Kapnick.com to learn more.
*Written in collaboration with Tyler Horning – Principal at TDC Life