If you own a business or a part of a business of any kind, you need to know about how a buy sell agreement works and even further than that, you’d better make sure it’s funded correctly (not from the corporate checkbook). Now, you could roll the dice, ignore the whole issue and just go into business with your partner’s wife when he dies but I’ve seen this happen on several occasions—not pretty. Most would who’ve been in this predicament would liken it to water-boarding, it won’t kill you but it might make your life and theirs, miserable.
Most business owners who haven’t funded their buy sell agreement fail to do so because they fear the expense. Which is really not based in reality at all, in fact, the cost of a funded buy- sell(life insurance premium) is peanuts compared to the benefit it provides. And without one a family business or closely held business can be in for serious financial and tax pain upon the death of an owner.
The Cross-Purchase Buy Sell Agreement
This is the most basic type of agreement and it’s a good place to build your foundational knowledge on the subject.
In a basic cross purchase agreement, when a business owner dies, the surviving owners agree to buy the deceased owner(s) shares of the business. Each owner agrees to purchase the others interest in the event that one of the others dies. So, in this scenario, every owner is an applicant, a premium payor, a beneficiary, and an owner of insurance policies on the lives of each of the other business owners.
Clear as mud right?
Hang in there, I’ve got a picture that will help sort it all out.
When one owner dies, every surviving owner/beneficiary will receive the insurance policy death benefit. Then each surviving owner pays cash to the deceased owner’s estate or family (depending on how the agreement is set up) and in exchange the estate transfers the deceased owner’s shares of the company.
What results is that family’s illiquid shares of the company are magically turned into cash, and the owners that are still living own all of the business. Everybody wins, the family got cash and the surviving owners aren’t forced to be in business with the deceased owner’s family.
How Does it Work?
Let’s use Bob and Sam as our example. They own XYZ Magic Button company.
- Bob and Sam establish a cross-purchase agreement between themselves.
- Bob and Sam apply for a life insurance policy on each other. Each one of them is the owner, beneficiary, and premium payor of a policy on the other’s life.
- Let’s assume that Bob dies, the life insurance company pays Sam the death benefit.
- Bob’s shares of XYZ pass to his estate/family.
- Bob’s estate/family sell their shares to Sam under the pre-arranged cross-purchase agreement.
- Sam uses the life insurance proceeds to pay Bob’s family cash for Bob’s shares in XYZ.
- Now Sam owns 100% of XYZ Magic Button Co.
Here’s a picture to illustrate all that happens.
Establishing a Value for the business
This is one of the most important aspects of the agreement, Sam and Bob have to sit down and fix a value for their company. In order for them to both be sure that the arrangement is properly funded, they both need to have enough life insurance coverage on each other to the “date of death” value of the deceased owner’s shares. There are several ways for them to arrive at a business valuation:
- An appraisal value—which is determined by an independent appraisal at the time the business interest is actually sold
- The Capitalized Earnings Approach—value is determined by an income based model. It derives the value of the business by dividing the selling party’s discretionary earning by the capitlization rate.
- Specific Fixed Price—the owners fix the price on a regular basis by agreement
- Formula Value—determined formula comprised of several factors that owners agree to in the cross purchase
- Book Value—the actually book value of the owners shares on the date of death
What are the Advantages?
Well, besides the obvious advantages that I’ve already discussed, there are others that are much more concrete in nature. If Bob dies and Sam purchases all of Bob’s shares per the cross purchase agreement they had in place, Sam receives an increase in the cost basis of the acquired shares that equals the full purchase price.
This is a very good thing for Sam. If later on down the road, he decides to sell all of XYZ Magic Button Company at least half of his shares will have a much higher cost basis which will lessen the capital gains pinch.
Also, there are at least two other advantages that are related, the business is not involved in the buy sell agreement in any official capacity at all which means
- The business is not forced to reflect the value of the life insurance on its balance sheet. This would cause the value of the business to increase.
- Because the business is not a party any of the transactions, the life insurance is not subject to Alternative Minimum Tax (AMT) calculation.
Are there any disadvantages?
There are a couple of the things that could complicate matters and make a cross purchase type of buy sell agreement not so fabulous.
- If there are too many owners, there can quickly become an obscene number of policies that have to be purchased to make the agreement work. The formula to calculate the number of policies need is N(N-1), where N equals the number of owners. Example: If there were five owners, 20 policies would have to be purchased…seriously? That gets a little out of hand.
- The owners could violate transfer-for-value rules if in order to fund subsequent buyouts, the decedent’s estate transfers all the remaining policies over to the surviving owners. But there’s much more to this that I just can’t get into here as it’s a topic unto itself.
In the end, it’s always best if you have a competent attorney and/or tax advisor involved in the process of deciding upon the right type of buy sell agreement your business should have.