Protecting the Life of Your Business with a Buy-Sell Agreement

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Do you ever wonder what would happen to your business and all the effort you’ve put into it if you or one of your business partners were to get sick, injured, or pass away? It’s important to consider this possibility, despite having a strong and shared vision for your business and working together diligently every day to achieve success.

A business does not need to become incapacitated or cease to exist simply because one of the owners retires, passes away, or becomes too ill or disabled to work. Whether the transfer of business management or ownership needs to occur after the owner’s death or during their lifetime, it can be effectively achieved through proper business succession planning.

A purchase agreement is a commonly utilized tool in the planning of transferring ownership of a business. When properly financed and designed, this planning feature can establish a structured and predetermined value for the business takeover, as well as designate the individual or individuals responsible for this takeover. This provides the owner with a sense of security, as they know that the business has a predetermined price at which it can be sold on the open market, ensuring that the owner has access to financial resources when needed, such as during retirement. In the event that the owner passes away before the predetermined value is reached, the purchase agreement can be utilized to fulfill the needs of the surviving individuals or to pay substantial estate taxes.

There are multiple methods to establish a buy-sell agreement, but the most commonly utilized ones are the entity purchase agreement and cross purchase.

Cross Purchase

Because of advantageous tax outcomes, numerous small businesses frequently employ this strategy. It is commonly embraced by businesses with a limited number of proprietors. Typically, the cross purchase is supported by an insurance policy for life and/or disability that each owner must uphold for their co-owners. The proceeds from the life insurance policy when someone passes away are not subject to taxation because the individual life insurance policies are owned by the owners themselves, not the business. It is compulsory, according to the law, for each business owner to buy the ownership share of the other co-owner(s) in case of death. The estate of the deceased owner sells the deceased owner’s stake to the remaining owners in return for the funds generated from the life insurance policy. The surviving owners will experience an increase in the business’s tax basis. Another option is to utilize the cash value of the insurance in the event that one of the co-owners needs funding for a buyout while they are still alive. It is important to note that when there are only a few owners, the management of a cross purchase is smoothest but becomes more challenging as the number of owners grows.

Entity Purchase Agreement

This form of purchase-agreement operates in a similar manner to the cross-purchase, however, it is the company, rather than the shareholders, that will hold an insurance policy on each shareholder and commit to buying the ownership stake of any shareholder who passes away. As a result, the tax implications are distinct.

The death benefits provided by both an entity purchase agreement and a cross purchase agreement, whether paid to the business or an individual, are not subject to federal income tax. However, unlike the cross purchase agreement, there are specific circumstances in which a C corporation may be liable for the corporate alternative minimum tax under the entity purchase agreement. Additionally, there is no increase in the basis of the plan under the entity purchase agreement.

Hopefully, this brief summary of the entity purchase and cross purchase buy-sell agreement types has made you realize the crucial significance of business succession planning for your company. Naturally, this concise piece couldn’t address all the aspects that need to be taken into account when creating a business succession plan. When you start the process of developing your business succession plan with your lawyer, accountant, and insurance agent, they should be able to address any further inquiries or apprehensions you may have.

Frequently Asked Questions

What is business succession planning and why is it important?

Business succession planning is the process of determining how the management or ownership of a business will be transferred when one of the owners retires, passes away, or becomes too ill or disabled to work. It is important because it ensures that the business does not become incapacitated or cease to exist simply because one of the owners is no longer able to participate, and provides a sense of security for the owner knowing that there is a predetermined plan for the business’s future.

What is a purchase agreement?

A purchase agreement is a tool commonly used in business succession planning that establishes a structured and predetermined value for the business takeover and designates the individual or individuals responsible for the takeover. It ensures that the owner has access to financial resources when needed and can also be utilized to fulfill the needs of surviving individuals or pay substantial estate taxes if the owner passes away before the predetermined value is reached.

What are the different methods to establish a buy-sell agreement?

There are multiple methods to establish a buy-sell agreement, but the two most commonly utilized ones are the entity purchase agreement and cross purchase.

What is the difference between an entity purchase agreement and a cross purchase?

In an entity purchase agreement, the company holds an insurance policy on each shareholder and commits to buying the ownership stake of any shareholder who passes away. In a cross purchase, each owner holds a life and/or disability insurance policy for their co-owners and is legally required to buy the ownership share of the other co-owner(s) in case of death. The main difference lies in who holds the insurance policy and is responsible for buying the ownership stake.

Are there any tax implications associated with entity purchase and cross purchase agreements?

Yes, there are tax implications associated with both types of agreements. The death benefits provided by both an entity purchase agreement and a cross purchase agreement are not subject to federal income tax. However, a C corporation may be liable for the corporate alternative minimum tax under the entity purchase agreement, and there is no increase in the basis of the plan under the entity purchase agreement. In contrast, the proceeds from the life insurance policy in a cross purchase are not subject to taxation because the individual life insurance policies are owned by the owners themselves, not the business, and the surviving owners will experience an increase in the business’s tax basis.

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