A buy/sell agreement is a contract that restricts business owners from freely transferring their ownership interests in a business. It is a tool for providing a planned and orderly transfer. Some of the important advantages of this type of agreement are:
• Provides for business continuity upon the death, disability, or retirement of a shareholder
• It establishes a market value for the corporation’s stock that might otherwise be difficult to sell
• It ensures that the ownership of the business remains with individuals selected by the owners or remains closely held
• It provides liquidity to the estate of a deceased shareholder to pay estate taxes
• It supports the deceased family members with proceeds upon the sale of the stock
A few disadvantages to a buy/sell agreement are:
• The cash paid for the life insurance premiums that fund the agreement is not available for business operations or shareholder personal expenses
• Circumstances may change after the agreement is adopted that cause purchasers to regret the obligation that they made to buy a withdrawing owner’s interest.
The contract can be between the shareholders of a corporation individually or between a corporation and a shareholder. The contract provides that a shareholder’s stock will be sold to the other shareholders or to the corporation upon an occurrence of a specified event. Events generally include death, disability, and retirement, but may also include divorce, bankruptcy or inability to practice due to licensure requirements. The agreement may also be designed as a right of first refusal in the event that one or more of the shareholders want to sell their stock.
In a redemption agreement, the shareholder and the corporation enter into a contract in which the shareholder agrees to sell their shares to the corporation for a certain price, term or circumstance that is specified in the agreement. If the stock redemption agreement is funded with life insurance, the corporation pays the premiums and the corporation owns the policy and is the policy’s beneficiary.
The costs of the insurance premiums are carried proportionately by all the shareholders because the corporation is responsible for all the premium payments. The administration of the arrangement is simplified because there is only one life insurance policy on each shareholder and the legal agreement can be drafted as a single document.
Redemption agreements can have complex tax implications and a potential for adverse income tax consequences. If a corporation pays more than the fair market value for the stock the selling shareholder could be deemed to receive a gift from the other shareholders or compensation from the corporation. If the corporation pays less than the stock’s fair market value, the remaining shareholders may have received either a gift or compensation. To qualify for tax advantaged sale treatment the transaction must meet some strict statutory requirements. If the corporation is the beneficiary of a life insurance policy that funds the stock redemption, the insurance proceeds could trigger Alternative Minimum Tax.
A cross purchase agreement is a contract between the shareholders of the corporation to offer their shares for sale to the other shareholders at the price and terms specified in the agreement. In the event of a shareholder’s death, the estate is normally required to offer the decedent’s ownership interest to the other shareholders at the specified price and terms. The other shareholders are generally obligated to buy the interest in the event of specified circumstances. These agreements are funded with insurance and therefore are best when a corporation has only 2 or 3 shareholders because each shareholder must carry life insurance on all the other shareholders which can be prohibitive.
Having no agreement is often the most costly of all because it can result in personal collateral damage. Shareholders become enemies and family members can become bankrupt. The decisions on exiting a business should always be made during the time of creation of the business and be readdressed regularly as circumstances come up that could affect the viability of a buy/sell agreement plan.
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