Planning for certain contingencies, such as death, disability, or retirement, is a concern that affects all business owners. For family businesses, in particular, continuation planning is inevitably intertwined with business, tax, and estate planning. One succession tool that can help ensure a smooth transition is the buy-sell agreement. These multifaceted agreements serve many valuable purposes, such as establishing a sale price for business interests; valuing an estate for estate tax purposes; providing liquidity; and easing the transfer of ownership between partners, family members, or a third party.
What Is a Buy-Sell Agreement?
There are three basic types of buy-sell agreements: cross-purchase, stock redemption, and hybrid. Depending on the number of owners, family involvement, and business structure, one type of agreement may be more appropriate for your purposes than another.
A cross-purchase agreement obligates shareholders to purchase the shares of another shareholder upon a triggering event, such as retirement, disability, or death. In the case of an owner’s death, for example, shareholders may be required, or have the option, to purchase a deceased shareholder’s stock, and the decedent’s estate would be required to sell, according to the terms specified in the agreement. Generally, this technique works well for small businesses with few owners.
A stock redemption agreement, also known as an entity purchase agreement, is one in which the business agrees to buy (or redeem) the stock of a retiring, disabled, or deceased shareholder. This type of agreement is relatively simple to structure and tends to be more suitable than the cross-purchase agreement for larger companies with multiple owners.
A hybrid agreement allows parties to incorporate aspects of both cross-purchase and stock redemption agreements. Generally, the shareholders agree to offer the stock to the corporation first, and then to other shareholders. The corporation may purchase all, or a percentage, of the stock, and the shareholders purchase the remaining stock.
With buy-sell agreements, payment may come from either the buyer or the business using, for example, money from the sale of assets or loans. Another common method for funding a buy-sell agreement is life insurance. In a cross-purchase agreement, each shareholder owns a policy on the life of every other shareholder. In the case of a stock redemption agreement, the corporation holds a policy on each shareholder.
In many cases, cross-purchase agreements offer advantages over redemption agreements. For example, surviving shareholders receive “stepped-up basis” for tax purposes equal to the value of the purchase price of the decedent’s stock. When life insurance is used to fund the agreement, company creditors cannot lay claim to any proceeds used to fund the agreement.
In 2020, individual taxpayers with total taxable income in excess of $441,451 are subject to a 20% tax rate on their long-term capital gains (excluding capital gains from collectibles and certain depreciable real property) and qualified dividends. All other taxpayers will continue to be taxed on their long-term capital gains (excluding capital gains from collectibles and certain depreciable real property) and qualified dividends at a maximum tax rate of 15%.
The most appropriate strategy for your business will depend on the number of owners, structure of the business, the scheduled transfer of ownership, the estimated time frame, and your personal financial goals and tax situation. Since business succession involves many ownership, tax, and management considerations, be sure to consult with your tax and legal professionals.