Buy-Sell agreements are often an overlooked, but critical part of planning for a business with two or more owners. The agreement can cover many different and unexpected circumstances. See my prior article for a discussion of the importance of buy-sell agreements.
There exist three basic types of buy-sell agreements.
1. Redemption Agreements
First is the redemption agreement, under which the business entity is required to buy the departing owner’s interest. Buy-sell agreements are usually funded with life insurance. If there are several owners, a redemption agreement reduces the number of life insurance policies needed. Only one policy in required for each owner, which is owned by the company.
2. Cross-Purchase Agreements
Second, there is the common cross-purchase agreement where the remaining owners have an obligation to purchase the departing owner’s interest. One benefit of this type of agreement is that the remaining owners that purchase the departing owner’s interest receive a stepped-up basis on the purchased interest. However, if there are several owners and life insurance is needed to fund the purchase if one of the owners dies, there will be a need for several more policies. For example, if there are four owners, under a cross-purchase agreement each owner must hold a policy on the lives of the other three owners. Thus, twelve life policies are needed instead of just four.
3. Hybrid Agreements
The third type is the hybrid agreement whereby the departing owner’s interest may first be offered to the remaining owners. If they elect not to exercise their right to purchase the departing owner’s interest, the entity is then required to purchase this interest. This provides maximum flexibility to address the situation based upon the circumstances that exist at the time the triggering event occurs.
Determining which type of buy-sell agreement is best suited to your situation requires extensive time and planning. The tax consequences to the entity as well as each owner must be considered. In addition, such there are non-tax issues such as the complexity of the agreement, various ownership issues and restrictions, as well as life insurance questions that must be examined. Also, certain ethical issues should be addressed relating to what the attorney’s role is in drafting the agreement and which parties the attorney represents since each of the owners as well as the business entity itself usually have differing interests