How Can a Buy-Sell Agreement Help Protect Assets For Future Generations?
There are three phases to estate planning. The first phase involves having your “core” documents in place; that includes your Last Will & Testament, General Power of Attorney and Healthcare Directive. Everyone needs their “core” estate planning documents. Wills can vary greatly, depending on size and complexity of an estate and a testator’s wishes and objectives. Over the years, most states have standardized their General Power of Attorney and Healthcare Directive forms, by statute.
The second phase of estate planning takes a deeper dive into what has created the estate. For instance, if a family’s estate is made up of closely-held business assets, an estate planner wants to have conversations with his or her client about preserving the value of that business. This might involve discussion about succession planning and liquidity matters.
The third phase of estate planning involves a potpourri of techniques to save estate taxes and protect assets for future generations. These techniques often involve setting up trusts and establishing gifting strategies to freeze estate tax values and reduce exposure to death taxes.
When a client has closely-held business assets, often times multiple individuals own the business. This could be multi-generational, where family members own equity in the business to have “skin in the game”, or merely where there are multiple owners who started the business originally. One objective of an owner of a closely-held business is to allow his or her family to enjoy the fruits of the business, even after the retirement or death of the owner.
There is no public market, by definition, for a closely-held business. Short of selling the business to a third party, a common mechanism to establish the fair market value of the business is to do so contractually among the owners with a buy-sell agreement, sometimes referred to as a shareholder’s agreement.
A buy-sell agreement is a contract that sets out the owner’s shares to be disposed of, and for what amount, in the event of retirement, disability or death. To “fund” a buy-sell agreement that sets out the value of an owner’s share, the buy-sell agreement is often accompanied by disability insurance or life insurance.
The two most common types of buy-sell agreements are a stock redemption or entity purchase agreement, and a cross-purchase agreement. A cross-purchase agreement among owners has numerous tax advantages and is generally preferred. Normally, a buy-sell agreement is drafted with a possibility of both scenarios. Buy-sell agreements that combine the two call for other shareholders to have the first option of purchasing a deceased shareholder’s interest. followed by the business redeeming the shares or units that are left.
Life insurance generally pays a tax-free death benefit to the beneficiary of the policy, which then can be used to purchase the business interest of the deceased insured. So, multiple owners can set up a cross-purchase buy-sell agreement and have the business pay for insurance policies on each of the owners, with the beneficiaries of each policy designated as the surviving shareholders (other than the insured). The surviving shareholders are contractually obligated to use the insurance proceeds to purchase the business interest from the deceased owner’s estate. Structured properly, the life insurance proceeds are tax-free, payable to the remaining surviving shareholders, who pay the fair market value to the estate of the deceased, obtaining an increased tax basis for the consideration paid. The decedent’s estate sees a step-up tax basis in the business interest at death, so, theoretically, no gain or loss is realized or recognized upon the sale.
This contrasts with the stock redemption or entity purchase type of buy-sell agreement, where the insurance proceeds are paid to the business entity which pays consideration to the owner’s estate for the business interest. The remaining owners do not receive any increased tax basis for the consideration paid to redeem the decedent’s interest. In the past, there have been situations where insurance paid to a business entity could subject that entity to alternative minimum tax on the life insurance proceeds – catastrophic, since life insurance proceeds are typically considered tax-free.
Most importantly, when life insurance proceeds are paid to a corporation, the IRS takes the position that those life insurance proceeds should be considered in the valuation of the company. Even though the proceeds will be paid out by the company to redeem the decedent’s business interest, the value of the business is boosted, therefore the decedent’s taxable estate is increased as a result of the death benefit being directed to the business rather than the remaining shareholders.
This unfortunate result was re-affirmed recently in Thomas Connelly vs. The United States, where the Eighth Circuit affirmed a district court decision and found that the life insurance proceeds were simply an asset that increased the shareholders’ equity of the business. The fair market value of the decedent’s business interest must account for that reality.
The lesson here is that insurance to fund a buy-sell agreement should not be owned by the business. It can be held by a trust which allocates the death benefit to the remaining surviving owners, who are obligated by the buy-sell agreement to use the proceeds to purchase the deceased’s interest of the business. This is in contrast to the role of key-man insurance that a business would carry in order to bridge the economic reality of the loss of a significant employee-owner, which is a different purpose then funding a buy-sell agreement.
All owners of closely held businesses should have succession planning in mind. To the extent that there are multiple owners and where buy-sell agreements are appropriate, a cross-purchase arrangement in the event of death is preferable to the stock redemption/purchase agreement. If the life insurance purchased in a buy-sell arrangement is insufficient to purchase the entire interest of the decedent, further cross-purchase or entity purchase arrangements could kick in with appropriate terms so that the buy-out will be less of a strain to the ongoing business.
Just like paying the light bill allows the business to continue to prosper, succession planning helps preserve the value for the owner’s family. When there are multiple owners, proper planning with the appropriate buy-sell agreement, attention to detail, and diligent follow up are necessary to make it effective and help assure that an owner’s family reaps the benefits of the owner’s entrepreneurship, hard work and success.
Hoffman & Associates represents hundreds of closely held business and has consulted and drafted hundreds of buy-sell agreements. Mainly, it is one of the most important aspects of estate planning.
