Family-owned businesses are often formed with the intent of passing ownership of the company to the next generation and beyond. However, the evolution of the family structure in today’s society could present some challenges for owners who want to ensure those who follow, share the same family values and business ambitions. As family units become more splintered through second and third marriages or children with different interests or values, it’s less certain that the business will end up in the right hands.
That’s why it is critical for family-owned businesses to map out a business continuation plan that specifies which family members are eligible to own a share of the business. At the core of a business continuation plan is the buy-sell agreement, a legal document that dictates when, how, and to whom the shares of a business will be legally transferred.
For the buy-sell agreement to be effective, however, it must be funded. This means that when death occurs, there must be capital in place to effectively buy out the family or estate of the deceased partner. For many, life insurance is the preferred method of funding agreements because, for a small investment, it can guarantee the funding of the agreed-upon purchase price at the exact time it’s needed.
All too often we have seen family businesses fall into the wrong hands because buy-sell agreements were not properly funded. Take a look at the following example to see how this plays out in real life.
A Buy-Sell Agreement in Action
Widgets, Inc. is a $2 million family-owned business founded by four brothers, each with a 25% stake in the company. Tim the eldest brother dies, leaving his spouse a 25% share in the company, worth $500,000. Unless the other three brothers want Tim’s spouse to become a partner in the business, they must be able to buy out her 25% share to make her whole. If the company or the partners don’t have the liquidity to buy her share, she could step in as a partner.
However, having the foresight to plan for such contingencies, the four brothers created a buy-sell agreement. They funded the agreement with a life insurance policy on each of their lives, with Widgets Inc. as the beneficiary. When Tim died, Widgets Inc. used the proceeds from the death benefit to buy the spouse’s share of the business. Additionally, the buy-sell agreement creates a contractual obligation for the spouse (or estate) to sell Widgets Inc to the brothers in order to avoid her “wanting” to become a partner.
For small businesses with multiple owners, two of the more commonly used agreements are:
- Stock purchase (entity plan)
Cross-purchase agreements are typically appropriate for smaller businesses with two owners, such as partnerships. The agreement is made between each owner who agrees to purchase the interest of the other owner at a specified price. Each owner owns a life insurance policy on the life of the other owner and is the beneficiary of the policy.
Under Section 162, the business can pay a bonus to the owners for the amount of premiums to be paid for the insurance policy The bonus compensation is tax-deductible to the business and taxable to the owners. To offset the tax liability, the business can purposefully adjust the amount of the bonus to cover both the insurance premiums and the taxes due on the bonus itself. Upon the death of an owner, the proceeds are paid to the surviving owners, which are then used to purchase the deceased owner’s interest from their estate. The surviving owners receive a 100 percent increase in the cost basis of the interests purchased. To reduce the number of insurance policies in situations with multiple owners, a “trusteed” buy-sell agreement administered by a professional trustee could be a viable alternative to a cross-purchase.
The Stock-Redemption (Entity Plan) Agreement
Stock-redemption (entity plan) agreements are appropriate for business entities formed as a C Corp, S Corp, or LLC. With this agreement, the business entity agrees to purchase the shares of each owner upon their death. The entity purchases and pays the premiums for life insurance policies on the lives of each owner, and the entity is also the beneficiary of the policies. The entity uses the life insurance proceeds to buy back the shares from the deceased owner’s estate. The premiums are not a deductible business expense (IRC Section 264), and the owners do not receive an increase to cost basis attributable to the purchase price of the shares.
Buy-in on the Buy Sell
In order to create a harmonious and prosperous family legacy with your business, it’s best to have some form of contractual buy/sell agreement in place. After all, being prepared for the unexpected is just good business, plain and simple. As far as the legacies of the business and the family are concerned, a funded buy-sell agreement could be the most important business document ever signed.