The Buy/Sell Agreement: A cornerstone for business and succession planning

[Ben McCann]

What would happen to your business in the event of premature death, termination or retirement of a partner or co-owner? Would the remaining owners have the funds available to continue the business? Would there be the risk of losing the business or would the remaining owners have to accept new or unwanted owners? how would the IRs value the business interest for estate tax purposes?

a Buy/sell agreement can help provide the answers.

What is a Buy/Sell Agreement?
a Buy/sell agreement is a legally binding contract that spells out what will happen to a business when a specifc
triggering event occurs. The event could be death, disability, retirement or resignation. The agreement provides a business arrangement in which one owner or owners agree to buy the other owner or owners’ interest in the business, at a pre-determined price.

Advantages of a Buy/Sell Agreement
a well-drafted, funded Buy/sell agreement is foundational in a good business succession strategy.
1. It allows for the continuation of the business in an agreed upon manner.
2. The current business owners can come to agreement (before an unexpected event occurs) on how to most
efficiently pass the business on should one die or leave.
3. If funded correctly, it provides the resources to carry-out the agreement.
4. It provides a price that is agreed to be fair.
5. The agreed upon price can be used to start, or may even be used in, the estate planning valuation process.

Implementing a Buy/sell agreement is one component of business planning and becomes part of the overall long-term business and succession planning. however, it just might be the advantages of implementing a Buy/sell agreement that could save the business.

Planning should include coordinating the Buy/sell agreement with other business and personal planning documents such as shareholder agreements, power of attorney, wills, right of first refusal or any necessary installment notes.

Implementing a Buy/Sell Agreement
There are two critical steps to making a Buy/sell agreement effective.

1. Drafting a legal agreement
There are several types of Buy/sell agreements: entity Purchase agreements, Cross Purchase agreements, Trusted Cross Purchase agreements and Wait and see agreements. People should consult their legal and tax advisors to decide the best type of agreement for their individual situation.

This step requires that a fair price for the business is determined and agreed upon (this may call for an accountant
familiar with the company and the specific business marketplace). as the business grows and events change, the Buy/sell agreement should be reviewed periodically. Reviews should include structure of the Buy/sell agreement, funding options and amounts.

2. Funding a Buy/Sell Agreement
now that the agreement is executed, it is time to look at how the owners will obtain the funds necessary to carry
out the terms of the agreement. Funding a Buy/Sell Agreement is critical to its success. There are several methods
for funding Buy/sell agreements. Purchasing life insurance, borrowing funds, creating a sinking fund or drafting an
installment note can provide funding for various triggering events. The objectives of the agreement, the resources
available, and the probability of an event occurring all need to be reviewed when determining a funding method.
For example, life insurance can be a simple, cost-effective way to fund a Buy/sell agreement that will be triggered upon death of an owner. life insurance has the unique advantage of providing the actual cash needed to carry out the terms of the agreement even in those unexpected cases where the “savings” time is cut short due to sudden death of one of the owners. additionally, based upon current laws, life insurance has several tax advantages.

How does a Buy/Sell Agreement work?
There are many variables that will come into play when drafting the agreement.
The majority of Buy/sell agreements are either entity Purchase agreements or Cross Purchase agreements.
under an entity Purchase agreement, the business purchases the life insurance contracts on the lives of the owners. at death of an owner, the death proceeds are paid to the business and used to purchase the deceased owner’s share of the business.
under a Cross Purchase agreement, the individual owners purchase life insurance. each business owner owns a life insurance contract on each of the other business owners. If there are two owners, there are two life insurance contracts. If there are three owners, each owns two life insurance contracts. The individual policy owners pay their own premiums.

There are many questions to be discussed when drafting a Buy/sell agreement. For example, should the agreement apply to only the current owners or should it be binding on all owners throughout the life of the business? should the agreement require the seller to sell and the buyer to buy or give the seller and/or the buyer the right of first refusal? should the buyout price be one price or change as the value of the business changes? What happens in the event an owner resigns or is dismissed?

Example of a Cross Purchase Agreement:

1. Owner #1 enters into a Buy/sell agreement with Owner #2. The Buy/sell agreement sets forth the agreed upon
manner and price for which, in the event of an owner’s death, the deceased owner’s business interest will be
purchased by the surviving business owner. ( There are various methods for valuing a business interest. although each particular situation varies, some of the common valuation methods include the Market approach, the Income approach, the asset approach, or the Owner’s estimate.)


2. Owner #1 purchases life insurance in the amount equal to the agreed purchase price should Owner #2 die. Owner #1 is the owner of the life insurance contract; Owner #2 is the insured. The beneficiary is Owner #1.

Owner #2 purchases a life insurance contract with Owner #2 as the beneficiary and the owner of that contract
and Owner #1 as the insured. The purpose of these two life insurance contracts is to provide the funds necessary to
carry out the terms of the Buy/sell agreement. The premiums are not deductible to either owner or to the business.

3. assume Owner #1 dies;

4. at the death of Owner #1, the life insurance contract purchased by Owner #2 will pay the death proceeds to
Owner #2, subject to the terms and conditions of the life insurance contract. The proceeds will be received tax-free,
under current tax laws.

5. Owner #2 now has sufficient funds to buy Owner #1’s business interest (now held in Owner #1’s estate). The
estate and the heirs now hold the cash proceeds. (The sale by Owner #1’s estate will receive capital gains tax treatment and a step-up in basis. Therefore there will be little or no recognition of taxes upon the sale.)

as the illustration shows, a Cross Purchase Buy/sell agreement will provide the surviving owner with the funds to continue the business. The heirs of the deceased owner will receive the agreed upon value of the deceased’s business interest.

Who should know about this?
• People who have a business but no Buy/sell agreement
• People who have a Buy/sell but have not yet funded it
• People who have a Buy/sell agreement but have not reviewed it recently
• People who have recently or are in the process of setting up a business

In summary, a Buy/sell agreement can be an effective tool to allow a business to continue after a triggering event. a Buy/sell agreement funded with life insurance can, in the event of death of an owner, provide the surviving owners the funds necessary to meet the terms of the agreement. The actual decision to implement a Buy/sell agreement is a planning decision that should include the owners and their professional advisors.