Every business owner will eventually get out of the business. In the absence of a child or other relative who can take his or her place, an owner needs to plan for the sale of his or her ownership interest.
Ownership in a small business often has little market appeal to anyone other than those already involved in the business. Consequently, the obvious buyers are the remaining owners.
A buy-sell agreement guarantees a buyer for a retiring or deceased owners interest in a business, thereby allowing the owner (or the owners heirs) to recover his or her investment. The agreement also fosters the continuation of the business by not allowing the departing owners interest to fall into the hands of outsiders - persons who may not be qualified to run the business or who may be incompatible with the remaining owners
UNDER A TYPICAL AGREEMENT, THESE CONDITIONS APPLY:
* If an owner wishes to retire, he or she must first offer to sell the interest to his or her associates, or to the business itself, before selling to a third party.
* Upon the death of an owner, the surviving owners or the business must buy, and the estate must sell , his or her interest.
* The purchase price is fixed or the agreement contains a formula to determine the price.
STOCK REDEMPTION OR CROSS-PURCHASE:
Stockholders implementing a buy-sell arrangement must generally chose between a stock redemption plan and a cross-purchasing agreement. Under a stock redemption plan, the corporation agrees to redeem the shares of a stockholder at his or her retirement, death or, perhaps, disability. The redeemed shares become treasury stock. To fund the redemption, the corporation owns and is beneficiary of a life policy insuring each stockholder.
Under a cross-purchase agreement, the stockholders agree to purchase the share of a withdrawing or deceased stockholder. To fund the purchase, each stockholder owns and is beneficiary of a policy on the life of every other stockholder.
There are no fixed rules for determining which type of buy-sell agreement is most appropriate for stockholders' particular needs and objectives. However, each type of arrangement has advantages that the stockholders need to consider.
Business Insurance Plans Advantages
HERE ARE SOME ADVANTAGES OF A STOCK REDEMPTION PLAN:
* Only one insurance policy is in force per stockholder.
* Policy cash values are available to the corporation; these values are not subject to creditors of the stockholders.
* The plan avoids transfer-for-value problems because a deceased or withdrawing stockholder has no ownership interest in policies that insure the remaining stockholders.
* The premiums are paid by the corporation (for a sub-S corporation) and are usually charged to the stockholders according to their relative ownership interest. Thus, an older stockholder with greater shares contributes more toward the premium insuring his life, reducing the burden on younger, less-paid minority owners.
* Because life insurance is an after-tax purchase, a stock redemption plan can be more cost-effective than a cross-purchase agreement if the corporate tax bracket is lower than the stockholders' tax brackets.
A CROSS-PURCHASE AGREEMENT OFFERS THESE ADVANTAGES:
* Stockholders who are buying achieve a step-up in basis equal to the price they pay for the withdrawing or decease owners shares. This is an important advantage for a C corporation or an S corporation on an accrual basis.
* Policy cash values are available to the stockholders. These value are not subject to creditors of the corporation.
* The agreement avoids the imposition of the alternative minimum tax (AMT), which may occur when a C corporation receives tax-free death proceeds under a stock redemption plan.
* The agreement may avoid unintended shifting of control that can occur with redemption.
* The search for a lower bracket taxpayer favors a cross-purchase plan if the stockholders are in lower tax brackets then that of the corporation.
WHAT ABOUT A TRUSTEED CROSS-PURCHASE AGREEMENT?
A major disadvantage of the traditional cross-purchase plan is the need for numerous policies when the corporation has more that two stockholders. For example: with five stockholders, twenty policies would be needed, four on each life. Funding the agreement with many small policies rather that one large policy on each owner is likely to result in higher costs and add confusion to the transaction.
A trusteed cross-purchase arrangement eliminates the need for multiple policies on each stockholders life, avoids the AMT, and provides the remaining stockholders with a stepped-up basis. For the benefit of the stockholders as a whole, a trust owns one insurance policy on each stockholder. Premium notices are sent to the corporation, which pays the premiums and then charges the salary or dividend account of each stockholder in proportion to his or her percentage of ownership.
At the death of a stockholder, the trustee collects the insurance proceeds and pays the purchase price to the decedents estate in exchange for a bill of sale of the stock to the remaining stockholders.
AGREEMENT MAY ESTABLISH ESTATE TAX VALUE:
A deceased stockholders ownership interest is included in his or her gross estate for federal estate tax purposes. The purchase price under a buy-sell agreement establishes the value of that interest if (1) the heirs are obligated to sell the interest, (2) the agreement contains either a fixed price or a formula of determining the price, (3) the agreement prohibits owners from disposing of their interest in a lifetime sale without first offering it to the owners at no more than the contract price, and (4) the fixed price or pricing formula was fair and adequate when the agreement was made.