• Buy-sell agreements facilitate the smooth transfer of business shares in the event of an owner’s death or disability.
• There are two main types of buy-sell agreements: entity-purchase, in which the business purchases a life insurance policy on each owner; and cross-purchase, in which owners purchase life insurance policies on each other.
• In establishing a buy-sell agreement, the parties must take into consideration the valuation of the business and equity stakes of the individual owners, as well as the income and estate tax implications of purchasing their stake in the business should a triggering event occur.

Buy-sell agreements are an important tool for business succession planning, in which business owners or partners decide how the available shares of a business should be distributed in the event of a partner's death, disability or retirement. 

The buy-sell agreement serves as the blueprint for the transition of a business, but does not provide the liquidity needed to fund it. While cash or third-party loans can be used to fund these agreements, life insurance policies are the most popular method of doing so, ensuring that the funds will be made available when they are needed most. 

How buy-sell agreements work

The two main buy-sell agreements are entity-purchase, also referred to as stock redemption, and cross-purchase:

Entity-purchase

An entity purchase buy-sell agreement is a contract between business owners and the business itself. In an entity-purchase agreement, the business buys life insurance policies on each owner, with the business itself as the beneficiary. If an owner is disabled or passes away, the life insurance policy is triggered, and the death benefit used to purchase his or her shares of the business. This protects remaining owners from financial difficulties and conflicts that may arise, while ensuring a fair price and continuity for the business.

Entity-purchase agreements require only one policy per owner, generally making administration easier than in cross-purchase agreements. Premiums are paid using business dollars, and any cash value in the policy becomes a business asset, appearing on the corporate balance sheet. 

However, in an entity-purchase agreement, surviving owners do not receive a stepped-up basis on the purchased shares when an owner dies; and the death benefit may increase the business value for estate tax purposes. 

Policies can also be subject to corporate creditors, and Section 101(j) compliance is necessary to keep the death benefit income tax-free. Premiums paid on the life insurance policy are not tax-deductible as a business expense.

Cross-purchase

A cross-purchase buy-sell agreement is a financial arrangement between business owners, where each owner holds a life insurance policy on the other owners and names themselves as the beneficiary. In the event of an owner's death, the surviving owners use the policy's tax-free death benefit to purchase the deceased owner's shares from their spouse/estate, proportionally. This arrangement offers advantages, such as a step-up in basis for the surviving owners, protection from corporate creditors, and exemption from potential corporate Alternative Minimum Tax (AMT). Additionally, compliance with Section 101(j) is generally not required.

However, cross-purchase agreements can be complex to administer due to the number of policies needed, calculated as N x (N-1), where N is the number of business owners. For instance, a firm of four partners would require each to hold three policies—12 collectively. This agreement may also create an imbalance in premium costs if there is a significant age or health difference among the owners. 

While premiums are funded personally, the business may provide a bonus to cover the premium. 

Potential applications

Cross-purchase buy-sell agreements are suitable for co-owners of a business, such as partners or shareholders. They are ideal for businesses with a small number of owners, as the number of required policies increases exponentially with each additional owner. 

Business owners who want to avoid potential exposure to corporate creditors or potential corporate Alternative Minimum Tax implications may consider cross-purchase agreements. Additionally, these agreements ensure a step-up in basis for the purchased shares, reducing future capital gains taxes.

Entity-purchase agreements are best for businesses with a significant number of owners, as they simplify the buy-sell process and require fewer life insurance policies. These agreements are suitable for businesses that prefer to use corporate funds to pay premiums and those with specific financial needs that must be addressed with the agreement.

The cash value of the life insurance policy is an asset on the corporate balance sheet, and the agreement provides a predetermined valuation and sale process. Businesses with an owner in poor health may consider an entity-purchase agreement, as it avoids the issue of other owners having to pay a higher premium in a cross-purchase agreement.

Product selection

While a term policy may be the lowest cost life insurance product to implement in a buy-sell agreement, there may be some added value to utilizing a permanent insurance product. 

In an entity-purchase agreement, the cash value of a permanent policy is a corporate asset and shows up on the balance sheet. In the case of a financial emergency, the business would be able to access the cash value of the policy. 

In both entity- and cross-purchase agreements, in the more likely event that the business owner retires versus passing away, the policy can be transferred over to him or her to supplement their retirement.  The policy can also be used as part of the buyout agreement. 

Case study

Kim, age 40, and Pamela, age 45, are sisters and are both in good health.  They are co-owners of a successful restaurant business, but are concerned about coming up with the necessary funds to buy out the shares of the other should one of them pass away unexpectedly. 

Their corporate accountant suggests setting up a cross-purchase buy-sell agreement that would provide the surviving owner with the funds to buy out the deceased owner’s shares from the husband/estate. 

The business is valued at approximately $1,000,000 and they are equal owners.  In this cross-purchase agreement, Kim would apply for and own a life insurance policy for $500,000 on Pamela and name herself as beneficiary.  Similarly, Pamela would apply for and own a life insurance policy for $500,000 on Kim and name herself as beneficiary.  

The premium on Pamela’s policy is slightly higher than Kim’s given her age, but the difference is negligible. (If a concern, the business could provide them each with an additional bonus to compensate for the difference.) Assuming that Kim dies prematurely, Pamela would receive the death benefit proceeds of $500,000 and be able to purchase the outstanding shares from Kim’s husband/estate. Were this to occur, Pamela’s cost basis in the business would increase by $500,000 at the time the shares are purchased.

Additional buy-sell agreements

Insurance LLC

An Insurance LLC is a Limited Liability Company (LLC) established with the sole purpose of owning, and being the beneficiary of, life insurance policies on the lives of each of the business owners. Each business owner is also a beneficial owner of the life insurance policies and contributes the funds necessary to pay for the life insurance premiums.

When one of the owners passes away, the LLC receives the proceeds and distributes them to the surviving members of the LLC, who then purchase the outstanding business shares from the deceased owner’s spouse/estate. The main advantage of establishing an Insurance LLC is that each owner receives a step-up in basis, similar to a cross-purchase agreement, but the number of policies needed is reduced down to just the number of owners in the business.  

One-way buy-sell

When a business has a sole owner, special problems could arise when he or she dies or becomes disabled. As opposed to a business with multiple owners who could buy out the deceased individual’s shares, a sole owner stands to lose all of the value they have built up in the business when they pass away. Further, the owner’s family/heirs may lose a source of income. 

A potential purchaser of the business - be it a family member, a key employee, or even an outside competitor - can purchase a life insurance policy on the life of the sole owner with the intention of buying out the deceased owner’s spouse/estate for the outstanding business shares. Proceeds can also be used to pay any outstanding debt owed by the business. The buyer would receive a step-up in basis when the shares are purchased.  

A buy-sell agreement is a legally binding agreement between business partners or co-owners that outlines the terms and conditions for buying out a departing owner's share or interest in the business.

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