Purposes and types of buy/sell agreements
The problems common to the various forms of business ownership regarding business continuity and the receipt of a fair value can be solved through a written buy/sell agreement. It is the most efficient way to provide for the orderly transfer of an ownership interest. The buy/sell agreement:
- Allows remaining owners to retain control.
- Ensures business continuity.
- Creates a guaranteed market for the business interest.
- Establishes the price of an owner’s interest
- Pegs the value of the interest for estate tax purposes in non-family transfers.
- Can be funded to provide a source of funds to ensure the seller or estate actually gets the promised money.
The existence of a buy/sell agreement offers remaining owners the security of knowing they will retain control. A well-planned transition enhances management stability and employee confidence and is reassuring to key staff. Third parties are equally concerned with the existence of an agreement which provides for successor management
Once the business owner has recognized the need for a buy/sell agreement, a series of decisions must be made regarding:
- the type of agreement.
- the value of the business interest.
- the funding of the agreement.
A buy/sell agreement can be structured as an Entity purchase or as a Cross purchase agreement.
The entity purchase agreement calls for the purchaser to be the entity itself whether it be the partnership or the corporation. An entity purchase in a corporation is called a Section 302 stock redemption or simply a stock redemption. While the end results are fundamentally the same, the differences lie in the tax consequences.
A combination, or “wait and see agreement,” allows buyers to choose either buy out method at execution and provides maximum flexibility.
A cross purchase agreement is a contract between individual partners or shareholders to purchase the interests of each other in the event of death or withdrawal from the business. The partnership or corporation is not involved in the agreement.
A buy/sell agreement may be artfully drafted and legally sound and yet fail to accomplish its objectives because of inadequate funding. There are only four ways to fund a buy/sell agreement and are discussed in more detail below:
- Current capital
- Sinking funds
- Borrowed funds
- Insurance financing
Every business must have funds in order to conduct its daily operations. These funds are called current or working capital. Any excess funds are accumulated earnings which the corporation can set aside for specific purposes. If no provision has been made for the obligation of the remaining shareholders, key employees or family members to pay for the purchase of the stock at death, disability or retirement, it is not likely that the dollars needed can be paid from current capital. If current capital must be used, the ability of the business to function is crippled
What happens if catastrophe strikes? An airplane or car accident can claim the lives of more than one owner. If more than one buyout must take place simultaneously, current capital would most certainly be insufficient. Funding with current capital is costly. Each dollar paid for the business interest is a nondeductible after-tax dollar
It is the unusual situation where a buy/sell agreement could be adequately funded by utilizing current capital. In most instances, it is tantamount to no funding at all.
- The use of current capital to purchase a business interest can cripple the business.
- Each dollar paid for the business interest is an after-tax dollar. Funding with current capital equals no funding
Another method used to fund a buy/sell agreement is the creation of a sinking fund.
- The fund is created for death or disability, this is only a viable solution when a business owner is uninsurable.
- A sinking fund is a common approach to funding for a sale at retirement.
- Deposits are made to the fund on a consistent basis in an attempt to meet the obligation created by the agreement.
The problem with this approach is that it may take years to build the necessary funds, but the death or disability of a shareholder may occur next week. One cannot predict exactly when the money will be needed.
Like the current capital approach, the sinking fund is an expensive way to fund the agreement.
Deposits are made with personal after-tax dollars for a cross purchase agreement and corporate after-tax dollars for a stock redemption agreement
The third option is for the buyer can borrow funds from a third party such as a bank in order to buy the business interest. If the funds are borrowed from a bank, a cash settlement is made to the seller or seller’s family.
The disadvantage is that the total amount paid for the business is a great deal more than the purchase price. The final cost depends upon the amount of interest paid and the length of the loan. If the business is the buyer, earnings must be sufficient to make the loan repayments.
If a sale occurs during lifetime, due to retirement for example, the retiring shareholder may agree to finance the sale. This is normally arranged as an installment sale where payments of principal and interest are spread over a stated number of years.
One disadvantage to the seller is that he or she must depend on the ongoing health of the new owner and the profitability of the business for continued payments.
Despite this disadvantage, seller financing is a common approach to a lifetime sale of a business interest.
- It offers an attractive tax advantage for the seller since any capital gains tax is spread over the installment payment period.
- In an installment sale, a portion of each installment payment is a return of capital, which is received free of income tax.
- Another portion represents favorably taxed capital gain, and the last portion is interest, which is taxed at ordinary income tax rates.
- The tax on the capital gain and interest is paid in the year the installment is received.
A business can lose a partner or key executive to death just as quickly and unexpectedly as termination of employment, and the blow can be a devastating one. The success or failure of a small or medium-sized business can hinge on the abilities of just a few key executives—usually owners and their key management employees.
The removal of one of these key players through death can quickly turn business success to business failure, unless the business has taken steps to offset the economic loss that will result from the death of a key executive.
A well-managed company wouldn’t think of not insuring its property against loss, and yet life insurance on key executives may be a far more vital need. Consider that:
- Statistics tell us that the odds of the death of a key executive are far greater than the odds of a fire loss.
- Death is always a complete loss, while property may just be partially lost. Replaced property is likely to be newer and more efficient; a replaced key executive may not be.
An insurance policy can be used to buy the shares from the estate of a partner if that individual dies. The business or remaining partners would then own the shares of the deceased partner.
A Life insurance policy can be used to fund a Buy Sell agreement if a partner decides to retire or leave the business for another reason. Buy using the proper life policy, you can serve two purposes—protection in case of death and cash for buy back of shares. A properly structured policy will accumulate cash value to be used at a later date to purchase the shares of a departing shareholder which will reduce the financial burden of finding capital when needed.