If you are a business owner, you have not planned sufficiently for the future without a buy-sell agreement.
A buy-sell agreement decrees how a business, or share of a business, will be transferred upon death, disability or retirement. The agreement can be between partners, between a business entity and its stockholders, or between an owner and a key employee. It predetermines who will receive a business (or shares of a business) and how the sale or transfer will be funded.
It also provides a means for paying personal estate taxes after the transfer.
Agreement types
There are three basic types of buy-sell agreements. All determine the value of the business through an updated business valuation or formula derived from an older valuation.
The first is a stock redemption plan, which is an agreement between a corporation and its shareholders.
A second type is a cross-purchase plan, which is an agreement usually among shareholders or partners.
A third option is a wait-and-see plan. This plan offers flexibility and tax and economic advantages, combining the best from the first two options. In this buy-sell scenario, a corporation can exercise its buyback option or waive its right, thus triggering a cross-purchase option.
Regardless of which plan is chosen, business owners should consult with a professional to avoid tricky tax and procedural pitfalls. As mentioned in Limra’s MarketFacts Quarterly (2003), “Creating a buy/sell agreement without any funding consideration is like throwing a bullet instead of shooting it.”
Financing the agreement
When a business or its shares become available because of a death, surviving owners again get the first option to buy, even though the business interest is usually willed to a family estate.
Most buy-sell plans include the stipulation that surviving family members, if not previously involved in the day-to-day business operations, sell their interest to surviving owners. The cash received for this interest helps meet family estate-tax obligations and the business goes to the people best qualified to run it.
Self-funding, borrowing and insuring a buyout are the three basic ways most buy-sell plans are funded.
With self-funding, surviving owners or shareholders can either pay for the business interest outright or through an installment plan. Buyout funds can also be accumulated through the establishment of a sinking fund ‑ a savings plan in which business owners regularly put aside money for the sole purpose of buying shares when they become available.
While this funding arrangement helps money accumulate for the future (while earning interest), borrowing provides the money up front, with interest payments figured into future payments.
But what if death or disability occurs before enough funds have accumulated to meet the buying price? What if borrowing becomes tight because the departure has an adverse affect on business? Can a deceased owner’s estate afford to wait for an installment plan?
This is where insurance comes in. Bought by either the company or by partners, insurance is a way to provide cash when it’s needed. Through a variety of insurance programs such as split-dollar, in which an insured owner and other partners split the cost, tax-advantaged savings can be accomplished now while future payout is guaranteed. Whole life insurance, which builds cash value, can also provide needed funds when events other than death trigger a buyout clause. And many companies now sell disability insurance to specifically meet buy-sell needs.
The existence of a buy-sell plan ensures the orderly transition of a business, and a proper funding vehicle ensures the money will be there when the time comes. Plan for the future now. Your business depends on it.
Guarantees are dependent on the claims-paying ability of the issuing company.
This information is not intended as tax or legal advice. Please consult with your attorney or accountant prior to acting upon any of the information contained in this article.
Keith D. Johnson is an associate of National Financial Services Group (www.nationalfinancialservicesgroup.com). He focuses on holistic financial planning to help business owners create and preserve multigenerational wealth. Johnson is a registered representative and investment adviser representative of Equity Services Inc. Securities and investment advisory services are offered solely by Equity Services Inc., Member NASD/SPIC, 1050 Crown Pointe Parkway Suite 1000, Atlanta, GA 30338. Reach Johnson at (770) 512-5139 or [email protected].
