Buy-sell Agreement Key To Future Of Business

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Reprinted From: New Castle Business Ledger
Written By: Nancy F. Blumberg, CPA-PFS, CFP
The closely held business is usually the largest and most important asset of the family. It often provides the primary source of income for one or more family members. Therefore, a successful transfer of the business to the next generation is necessary to ensure financial security to the retiring business owner and perpetuate the family wealth for the next generation.

Buy-sell agreements are an important document in the transfer of closely held businesses. A buy-sell agreement is a contract that creates the procedures for buying out an owner's interest 'in a closely held business in such events as divorce, death, disability, or retirement. The agreement establishes the mechanics to arrive at the purchase price and other conditions of the buy out.

A properly planned and drafted buy-sell agreement serves many purposes. It can avoid costly disruptions of managing the closely held business if something should happen to an owner. It serves to preserve control among existing owners, if desired, and it establishes a market for an otherwise liquid asset. Establishing a method for determining a fair price and the terms of the buy out can save many hours of dispute and frustration after a triggering event occurs.

The determination of a fair price, fixed by a buy-sell agreement, may be helpful in estate tax planning as well as in determining the estate tax value. There are two basic forms of buy--sell agreements: entity-purchase agreements and cross purchase agreements. Under an entity--purchase agreement the business itself is obligated to buy the shareholder's interest. A cross--purchase agreement is an agreement among the owners to purchase each other's interest. The factors to consider in selecting the form of buy-sell agreement for the business include the number of owners, the method of funding (insurance) and the income tax consequences. When there are several owners and a cross purchase agreement is considered, the use of a business insurance trust may be appropriate to reduce the number of insurance policies needed.

There are many considerations that need careful attention before a buy-sell agreement can be structured. How is a fair price established? What payment terms can be handled by the corporation without placing a burden on the business? Can other shareholders provide funds for a purchase? Should insurance be used to fund the buy-sell agreement, and how much? What events should trigger the buy-sell?

The tax treatment of any redemption is also an important consideration.

For example, in a cross--purchase agreement the income realized on the sale is characterized as a capital gain. In an entity--purchase agreement the funds received from the redemption must meet certain tests to be taxed as capital gain.

Therefore, the distribution could be taxed as a dividend and no tax basis allowed against it.

Currently, most buy-sell agreements for C and S corporations are structured as cross-purchase agreements. This is due to the tax disadvantages of entity-purchases. When using an entity-purchase, a C corporation may be subject to the Alternative Minimum Tax (AMT) if insurance proceeds are used for funding.

Insurance as a funding vehicle for the buy-sell may also compound an accumulated earnings problem for a C corporation that has retained excess earnings. For the S corporation there is an advantage to the cross--purchase agreement because it will result in an 'increased basis to the purchasing shareholders. It is paramount for the owners of a closely held business to plan for the retirement, death or disability of a shareholder. A buy-sell agreement is a necessary component of the planning process. It is also prudent to periodically evaluate any existing agreement (if one is in place) and the insurance coverage necessary to fund it to be confident that they meet the present needs of both the family and the business.