Arranging a Buy-Sell Agreement
Before you create a buy-sell agreement, it is important that you consider your goals and family situation and familiarize yourself with the different arrangements. We also recommend talking to a business estate planning attorney in order to choose the most appropriate arrangement.
There are several possible arrangements for structuring a buy-sell-agreement:
The entity purchase agreement uses a contract between the business and each of the owners. Under the terms of the agreement, the business promises to purchase the interest of a departing, disabled, or deceased owner, and each owner promises to sell.
When the buy-sell agreement is funded with life insurance, the business owns a policy on each owner. The business is named as the beneficiary and pays the premiums. At the death of an owner, the business receives the policy benefits, which may be used to meet purchase obligations.
NOTE: Any form of business other than a sole proprietor may establish an entity purchase buy-sell agreement. This method of establishing a funded buy-sell agreement is particularly useful when there is a desire to have your business pay for the insurance products funding the buy-sell or in situations where the use of other methods of establishing the plan would be impractical.
Entity Purchase Agreements
Family Attribution Rules
A stock redemption, except under Internal Revenue Code (IRC) Section 303, will usually terminate the estate's or heir's interest in the corporation. The problem is that the estate or heir may be treated under the attribution rules as constructively owning stock actually owned by others: spouse, children, grandchildren, or parents (and also certain entities such as trusts, estates, and businesses).
However, assuming all direct interests in the corporation have ceased, including any interest as an officer, director, or employee (being a creditor is permitted), the family attribution rules may be waived by filing an agreement with the IRS not to reacquire an interest in the corporation in the next 10 years. This will then allow a redemption to be a complete termination of interest despite continuing ownership by close family members.
NOTE that the entity attribution rules may not be waived.
Section 303 Redemption
Congress has recognized the unique estate liquidity problem faced by the estates of deceased shareholders of family corporations. Often, such shareholders want to retain the business within the family. But the sudden liquidity needs arising at death death taxes, probate costs, funeral expenses, etc. could require these estates to sell off part of the business to generate cash. This would create a new problem: outsiders coming into the business. Or, if the corporation redeemed part of its stock to get cash into the estate, the corporation's distribution could be treated as a dividend.
For this reason, Congress passed a special provision, Section 303 of the Internal Revenue Code. In brief, Section 303 allows a shareholder's estate or heir to sell to the closely held corporation enough stock to pay federal and state death taxes, costs of estate administration, and funeral expenses without treating the transaction as a dividend to the redeeming shareholder.
The cross purchase method of establishing a buy-sell agreement uses a contract between the co-owners. The business itself is not a party to the contract.
Each owner agrees to purchase a share of a departing or deceased owner's business interest according to terms spelled out in the contract.
When the cross purchase agreement is funded with insurance, each owner pays the premium and is the beneficiary of a policy on all the other business owners. At the death of an owner, each co-owner receives policy benefits, which may be used to meet purchase obligations.
Trusteed Cross Purchase Arrangements
Trusteed cross purchase arrangements use a revocable trust and a trustee to manage the insurance policies and fulfill the terms of the buy-sell agreement.
Trusteed arrangements may be advantageous when there are more than three partners or members. Under this arrangement, the trustee purchases only one policy on each owner, minimizing the number of insurance policies that need to be purchased.
Transfer for Value
A potential tax problem arises when you have a trusteed cross purchase arrangement among corporate shareholders. When a shareholder dies, the surviving shareholders will succeed to the beneficial ownership of the remaining policies by the trustee. There has been some speculation that this may be a transfer for value that would cause a forfeiture of the income tax exemption for death proceeds. This problem does not arise for transferee partners, who enjoy an exemption from the transfer-for-value rule.
This form of buy-sell agreement is used when only one of the parties to the agreement is selling an ownership interest. If life insurance is used, the purchasing party obtains insurance on the life of the business owner, pays the premium, and is named as the beneficiary.
At the death of the selling owner, the policy proceeds are paid to the purchasing party and may be used to assist in meeting purchase obligations spelled out in the buy-sell agreement.
Because buy-sell agreements are established to meet contingencies that may not occur for many years, it is sometimes difficult to know which method of establishing the buy-sell plan will be best when the plan is actually needed.
To accommodate a need to postpone the decision about whether the business or the co-owners will purchase the business interest, a wait-and-see buy-sell agreement may be used.
The wait-and-see buy-sell agreement is a special type of buy-sell agreement between the owners of a business and the business itself. Unlike the traditional entity buy-sell and cross-purchase agreements, the specific purchaser of an owner's business interest remains uncertain until death, retirement, or disability actually occurs.
Let's take an example with three shareholders: Tracy, Derek, and Helen. In the typical wait-and-see buy-sell agreement, this would be the situation at Tracy's death:
- The corporation would have a first option to buy Tracy's stock from her estate.
- Should the corporation fail to exercise this option, or exercise it only with respect to a portion of Tracy's stock, then Derek and Helen would have a second option to buy Tracy's stock (or the remainder of it).
- If Derek and Helen should leave any of Tracy's stock unpurchased, then the corporation must purchase any remaining portion (or all) of Tracy's stock. This assures Tracy's family that all the stock will be purchased and assures the surviving shareholders that they will succeed to full control of the corporation.
The wait-and-see approach is obviously not appropriate for a sole proprietorship or a single-owner corporation. Further, if the owners are related, the family attribution rules are a potential problem in the event of a redemption under the first option or a mandatory purchase under the third step.
Western & Southern Life does not give tax advice. Please contact your tax advisor for information that applies to your situation.