Buy-Sell Agreements: Protect Your Ownership Interest in the Event of Death
Business owners often have concerns over what would happen to their ownership interests when an owner dies. Some of these concerns include whether the owner’s descendants will inherit economic interests, voting rights or both.
These concerns can be dealt with by entering into a properly drafted Buy-Sell Agreement that can be included in or be separate from an operating, partnership or shareholder agreement. There are several options available and the best option for a particular entity and its owners is determined on a case-by-case basis.
A Buy-Sell Agreement can be drafted to require that an owner’s business interests be bought out upon the occurrence of certain triggering events such as death, disability, bankruptcy, divorce, etc. In this article, we will focus on death as the triggering event. This mechanism is primarily funded by the use of life insurance policies and, if properly drafted, can establish the estate tax valuation of the deceased owner’s interest.
Here are the three most common mechanisms, as well as some of the risks involved in each.
The first option is a Redemption Agreement. In this scenario, the Company buys a life insurance policy on the owner’s life, pays its premiums and is named as the beneficiary of the policy. The amount of the policy will generally equal the agreed upon purchase price of the ownership interests as set forth in the Agreement. When the owner dies, the proceeds of the policy are paid to the company and are usually tax free. The company would then purchase the deceased owner’s interest with the life insurance proceeds. Since we cannot predict the moment of death, the disadvantage here is that the proceeds may be exposed to the company’s creditors. Furthermore, the deceased owner’s estate might have to pay a capital gain on the basis of the interest being transferred. There are also estate tax valuation concerns which can only be mitigated by a properly drafted Agreement.
The second option is a Cross Purchase Agreement. This vehicle is an agreement between the owners to own life insurance policies on each other’s lives, pay the premiums on the policy each one owns, and be the beneficiary of each other’s policy. Upon the death of one owner, the remaining owners receive the proceeds of the policy tax free. The surviving owners must then use these proceeds to purchase the interest of the deceased owner. A Cross Purchase Agreement is definitely not for everyone. For example, there is a risk that one of the owners will breach the agreement since money has to flow through one owner before it goes to the other. The deceased owner’s estate or family may have to sue the surviving owner to enforce the agreement sometimes delaying the administration of their estate. If the surviving owner has any judgments at the time, the creditors may even intercept the funds before anyone has a chance to fulfill the agreement.
The third option is a Trusteed Buy Sell Agreement where the owners form a trust and appoint a neutral third-party trustee to purchase a life insurance policy on the life of each owner and hold title to the ownership. The trustee is named as the beneficiary of the policies and thus receives the policy proceeds when an owner dies. The trustee must then pay the deceased owner’s estate the amount of the proceeds in exchange for the deceased owner’s interest in the company and later distribute this interest to the surviving owner(s) in accordance with the terms of the Trust. This mechanism ensures the proceeds are used for their intended purpose. However, there is normally no step-up in basis so the difference between the insurance proceeds and the basis of the deceased owner be taxed. The proceeds may also be included in the deceased owner’s estate if the insured had incidents of ownership with respect to the policy (e.g. if the insured had the right to revoke or amend the trust). This could result in double taxation but may still be avoided with proper legal drafting.
In summary, there are various legal methods to protect your ownership interest in a business in the case of a triggering event. However, these mechanisms are complex and if not carefully established can lead to a quite different result than the owners wanted and/or protracted litigation. These arrangements should therefore only be established with the help of an attorney well versed in the area who can work effectively with your insurance professional and your CPA to further advise you on potential tax implications.