Imagine the following scenario: You run a successful business with your business partner of 20 years. Your business partner dies unexpectedly. After the funeral, your deceased partner’s spouse shows up at your office with her two grown children. They ask for the key to your partner’s office – not to clean it out, but to move in. They are your new partner, whether you like it or not. That is the nightmare scenario business owners face when they don’t have properly drafted, fully-funded buy-sell agreement in place.

What happens to the business when a partner dies?

If you are in a business with multiple owners, each owner has an interest in the business based on the terms of their partnership or corporate agreement. That business interest has a certain monetary value based on its proportionate share of the business. When a partner dies, his business interest becomes part of his estate. The partner’s survivors are entitled to receive the value of the business interest.

Absent a financial arrangement to buy out your partner’s family, you may have only two options – neither of your choosing. First, you may be required to liquidate the business in order to raise the money owed to your partner’s family. Your second option may be to accept your partner’s spouse or his children as your new partner.

The critical importance of a buy-sell agreement

For any business with multiple owners or partners, one of their most critical planning issues is preparing for business continuation in the event of the death of one of the owners or partners. Buy-sell agreements are the most effective way for business owners to plan for the orderly transfer of business interests where two or more owners are actively involved in the business. A properly crafted agreement can ensure that the business interests of the deceased partner will transfer in an orderly manner to the benefit and satisfaction of all parties. The agreement specified a formula for valuing each partner’s interests along with specific terms for purchasing their interests. A buy-sell agreement can also provide assurances to clients, employees and investors of the business’ stability during a time of transition.

For a buy-sell agreement to be effective, it must be funded to ensure the capital is available at the time of death of a partner. The preferred funding method for buy-sell agreements is life insurance. It is the most cost-effective means of creating the capital when it is needed. Using the valuation formula established in the agreement, an amount sufficient to buy out the interests of a surviving family is purchased on each owner. The coverage should also provide an extra reserve for the business to use to continue its operations and find a replacement if needed.

Depending on the number owners, the life insurance can be purchases by each owner on the life of the other owners (cross purchase agreement); or, the business can purchase and own the life insurance on each owner (entity plan).

Most buy-sell arrangements are structured in one of two ways: A cross purchase agreement or a stock purchase (entity plan) agreement. The determining factor is the number of owners who are party to the agreement.

Cross purchase agreement

For non-corporate businesses with three or fewer owners, a cross purchase agreement is the simplest and most effective. The cross purchase agreement is typically used in partnership structures. Each owner or partner owns a life insurance policy on the lives of the other owners and is named as the beneficiary on each policy. Under Section 162 of the tax code, the business may bonus the amount of the premiums to the owners, which is tax deductible to the business and taxable as compensation to the owners.

Upon the death of an owner, the proceeds of the policy are paid to surviving owners, who then use them to purchase the interests of the deceased owner from his estate. The surviving owners receive a 100 percent step-up in the cost basis of the interests purchased.

Stock redemption or entity plan agreement

A stock redemption arrangement is best suited for businesses structured as a C-Corp, S-Corp or LLC. In all cases, the business, or entity, agrees to purchase the shares of the owners upon their death. The entity purchases a life insurance policy on each owner and is the named beneficiary of the policies. The premium payments are not deductible business expense.

Upon the death of an owner, the entity uses the death benefit proceeds to buy back the shares from the deceased owner’s estate. Depending on the legal structure of the business, the surviving owners may or may not receive a step-up in the cost basis of the purchased shares. In a C-Corp, the owners do not receive a step-up in the cost basis, while, in an S-Corp, the owners receive a 100 percent step up under certain conditions. Owners in an LLC may receive a step up that is proportionate to their share of the business.

For businesses owners, a buy-sell agreement may be the most important planning tool they will ever need. It is also a complex legal document which should be drafted by a business attorney. Because there can be tax implications in the transfer of business interests, for the business, the owners and their estates, the agreement should be reviewed by a qualified tax professional.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest.