You and your business partner or partners have a clear and common vision of how to run your business, where it's going, and how it's going to get there.
As a team, you've worked together each and every day to share the daily demands and shape the success of your business. That said, have you thought about what would become of the business and all your hard work if you or one of your partners became ill, was injured, or died?
A business doesn't have to end just because one of the owners retires, dies, or becomes too sick or disabled to work. Whether the transition of management or ownership happens during life or after death, it can be accomplished in an orderly way through appropriate business succession planning.
A buy-sell agreement is a common tool used in succession planning. When correctly funded and designed, it can establish the value at which the business will be transferred and who will take over. For more on protecting ownership interests, see Safeguarding Business Ownership: The Role of Business Buy-Sell Insurance.
The owner can gain peace of mind from knowing the business has a predetermined basis for sale and a ready market, providing a source of funds for retirement or other needs. If an owner dies before that predetermined event, the buy-sell can help meet survivors' needs or cover estate taxes.
Although there are several ways to establish a buy-sell agreement, the two most often used are an entity purchase agreement and a cross purchase.
Cross Purchase
Because of favorable tax results, many small businesses use the cross-purchase approach. It is generally used by businesses with a small number of owners.
The cross purchase is typically funded with life and/or disability insurance policies that each owner maintains on their co-owners. The death benefits from those policies are not subject to federal income taxation since the owners, not the business, own the individual policies.
Each owner is legally obligated to purchase the ownership interest of the deceased owner. The deceased owner's estate sells the interest to the surviving owners in exchange for the insurance proceeds, and the surviving owners generally receive a step-up in the business's tax basis.
Alternatively, an insurance cash value can be used if a co-owner needs to fund a buyout during their lifetime. Administration is smoothest with a limited number of owners and becomes more complex as the owner count increases; for guidance on funding methods, see Life Insurance for Business Buy-Sell Agreements.
Entity Purchase Agreement
This type of buy-sell works similarly to the cross purchase, but the business itself, not the individual owners, maintains insurance policies on each owner and agrees to purchase any deceased owner's interest.
Death benefits paid under either an entity purchase or a cross purchase are generally exempt from federal income tax. However, an entity purchase can have different tax consequences for certain C corporations, and there is typically not a step-up in basis for surviving owners under an entity purchase plan.
Hopefully this overview of entity purchase and cross purchase agreements has prompted you to consider the importance of succession planning for your business. As you begin preparations for your business succession plan with your attorney and accountant, be sure to talk to an agent who can explain insurance funding options and answer questions specific to your situation.
Frequently Asked Questions
What is a buy-sell agreement?
A buy-sell agreement is a contract among business owners that establishes how an owner's interest will be transferred if they die, retire, or become disabled.
How are buy-sell agreements commonly funded?
They are often funded with life and disability insurance policies owned by the business or by the individual owners to provide liquidity for a buyout.
What is the main difference between a cross purchase and an entity purchase?
In a cross purchase, surviving owners buy the deceased owner's share directly; in an entity purchase, the business buys the share itself.
Will life insurance proceeds be taxed when used for a buyout?
Death benefits are generally exempt from federal income tax, but tax consequences can vary by business structure and other circumstances.