Funded buy-sell agreements protect business interests

Even if your estate executor could sell your interest to a partner or competitor, they may not be willing (or able) to pay a price you deem

adequate for your surviving family. Finally, if the sale is not considered an “arm’s length transaction,” the Internal Revenue Service might challenge its value for federal estate tax purposes.

Fortunately, there is a solution for all of these problems: a funded buy-sell agreement.

Legal document

In these arrangements, a binding legal document establishes the purchase price and obligates the designated buyer to make the purchase at your death.

If the designated buyer is not a family member, the stated purchase price generally “pegs” the value of your business interest for federal estate tax purposes.

To ensure that the necessary funds are available to the buyer, your life is insured for the required funding amount. Through this simple process, you can guarantee a buyer for your business interest at a full and fair price and, at the same time, ensure that your surviving family members will benefit accordingly.

The buyer can be a current business partner, key employee, or the business itself. The buyer’s identity will determine whether the buy-sell plan is structured as a cross-purchase or stock redemption (entity purchase) plan.

Cross-purchase plan

In a cross-purchase plan, the buyer is usually an existing business partner, key employee or even a competitor. The buyer enters into the binding buy-sell agreement with you establishing the terms of the sale as well as the purchase price.

The buyer also becomes the applicant, owner and beneficiary of a suitable life insurance policy insuring your life.

At your death, the buyer uses the policy’s tax-free death benefit to purchase the business interest from your estate. The purchase converts the business asset included in your estate to cash for your family.

Since your estate is entitled to a full “step up” in basis for all appreciated assets, the transaction will not generally result in a taxable gain.

Furthermore, the purchasing partner or employee will receive an increase in his own business cost basis equal to the purchase price paid. (Cross-purchase plans generally are established to include all business partners with each simultaneously entering into an identical buy-sell agreement.)

Stock-redemption plan

In business situations involving more than three or four partners, a cross-purchase may become cumbersome to implement and administer.

In such cases, a stock redemption (or entity purchase) plan may be the answer. Here, the buyer is the business itself. Consequently, you and your business enter into the binding buy-sell agreement and establish the purchase price. Your business becomes the owner and beneficiary of the funding life insurance on your life.

From there, the results are similar to the cross-purchase plan.

Upon your death, your business receives the policy’s proceeds income-tax free and uses them to consummate its buy-sell obligation. Since this process “retires” your stock in the business, your surviving partners now own 100 percent of the remaining voting shares. (Note that while your estate will still receive the same “step up” in basis for your business interest, your surviving partners will not realize an increase in their business cost basis since they were not the buyers. Also, stock redemption plans are generally not recommended where the existing partners are family members other than siblings.)

Hybrid, trusted plans

In addition to the basic buy-sell plans outlined above, an assortment of other options is available. These may include hybrid plans incorporating elements of both cross-purchase and stock redemption, trusteed cross-purchase plans for situations with multiple shareholders, and others designed for use in specific business situations.

A funded buy-sell agreement is the cornerstone of any business owner’s estate plan. Consult a qualified insurance professional to help you determine the proper structure and funding for your specific situation.

Alan Lockhart is president of Marketing Financial, a wholesaler of financial products offered through banks, CPAs, insurance and financial advisers. He may be reached at alan@marketingfinancial.com.