Buy-Sell Planning: Strategies for Competitive Businesses

Business Solutions

Preserve Your Business' Future

The business interest is often the single largest asset of a closely held business owners' estate. It is often used to provide the majority of current income and support to the business owner's family. Understanding the need for planning, then developing and implementing a succession plan is critical to the continued well-being of the family in the case of the death or disability of a business owner. 

The information provided is not written or intedned as specific tax or legal advice. MassMutual, its subsidiaries, employees, and representives are not authorized to give tax or legal advice. 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, includinf their own personal legal or tax counsel. 

NOT A BANK OR CREDIT UNION DEPOSITY OR OBLIGATION • NOT FDIC OR NCUA INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT GUARANTEED BY ANY BANK OR CREDIT UNION

Planning in the Event of the Owner’s Death

The most important guarantees to you as a business owner are the continuity of the business upon the death of another owner and the certainty that your estate will have an immediate guaranteed buyer for your interest at a price that represents fair market value. These guarantees require sound advance planning. In the absence of such preparation, problems can arise.

Problems for the Surviving Owners

The deceased owner’s heirs may:

• Insist upon an active role in management — whether or not they have the capability or compatibility.
• Insist on dividends being paid, which may cause double taxation and impairment of the firm’s ability to expand.
• Threaten to (or actually) sell to “outsiders.”
• Call for liquidation if they can’t get their way — resulting in the loss of jobs as well as income and wealth-building opportunities for the surviving owners.

Employees may:

• Feel insecure, and their morale may sag, along with their productivity.
• Terminate employment — further crippling the firm, causing costly replacement problems.

Creditors may:

• Tighten up on credit in light of the firm’s weakened and uncertain condition.

Provide for Your Family and Heirs

Without a buy-sell arrangement:

• They are left with an asset of real value that has no guaranteed market, and they may be forced to sell at distressed prices.

• They have lost the deceased owner’s salary but will receive no income to replace it.
• They may encounter delays in administration of the estate caused by the attempts to sell the business.

Fortunately, these undesirable consequences can be minimized through the use of a buy-sell arrangement.

A buy-sell agreement is a legally binding contract that requires one party to sell and another party to buy a particular ownership interest in a business in the event of the death, disability, or retirement of a partner or stockholder or upon certain other triggering events as specified in the contract. These agreements may be used by any type of business entity: sole proprietor, corporation, partnership, limited liability company (LLC), etc.

Under this arrangement, when an owner dies, if the provisions are carried out, the plan will ensure the prompt and orderly sale of his or her business. This benefits your family, your heirs, and the surviving owners of your business.

Protect Your Business and Family

There are two basic forms of buy-sell arrangements:

• An entity arrangement: The business purchases an owner’s entire interest at an agreed upon price upon death, disability, or retirement.

• A cross-purchase arrangement: The remaining owners purchase the withdrawing owner’s entire interest at an agreed upon price.

While the buy-sell agreement legally requires the survivors to buy and the estate to sell, the arrangement could fail if the survivors do not have the financial capacity to make the purchase following an owner’s death. Life insurance can be an excellent way to fund a buy-sell agreement.

Entity (Stock Redemption) Arrangement

In an entity arrangement, the corporation owns life insurance on the stockholders and uses the proceeds to purchase (redeem) their stock at death. Entity or stock redemption, in many ways, offers the virtues of simplicity and ease of administration. If the agreement is funded by life insurance, the corporation is the owner, premium payor, and beneficiary of a policy on the life of each stockholder. The premiums are nondeductible by the corporation.

The fact that the corporation can record the cash value of a policy as an asset on its balance sheet may be viewed as a plus by the insured’s accountants, bankers, and other financial professionals. When a stockholder dies, the corporation receives the proceeds income tax free and pays the proceeds to the decedent’s estate in exchange for the redemption of stock. They don’t own the decedent’s shares, and their ownership interest in the company will increase proportionately. But generally the shares are either cancelled or become treasury stock.

If you have 300 shares owned equally by three shareholders and you redeem A’s 100 shares, the corporation now owns 200 shares, and B and C now own 50% of the company, similar to a cross-purchase, where B and C don’t own A’s redeemed shares.

One drawback to the stock redemption arrangement is that the surviving stockholders are not able to increase the basis of their shares following redemption because the corporation has purchased the stock of the deceased stockholder.¹ This could affect the capital gain amount if the surviving shareholders ever were to gift or sell their respective shares.

If the stock redemption arrangement is selected for a family-owned corporation, the possible application of the attribution rules of Internal Revenue Code (IRC) § 318 could result in the characterization of the redemption as a taxable dividend rather than as a tax-free sale or exchange. Certain planning techniques can circumvent these rules and should be taken into account if a stock redemption arrangement is used for a family-owned business.

¹  It is possible to achieve an increase in basis for S Corporation surviving stockholders with a stock redemption plan if the corporation uses cash basis accounting. This is done by the survivors electing a short fiscal year when a stockholder dies. IRC § 1377, 1367(a).

Practice Tip: Step-Up in Basis to Surviving Owners

Important Note (If entity is taxed as a partnership): Whether the buy-sell arrangement is structured as an entity or a cross-purchase, the surviving partnership/LLC owners receive an increase in basis for the purchase of the decedent’s interest. With an entity arrangement this is achieved by allocating the insurance proceeds received by the LLC to the capital accounts of the surviving owners, which increases their basis in the LLC. With a cross-purchase arrangement, the surviving purchasing members get a direct increase in basis equal to the price they paid for the purchased interest with the insurance proceeds. Thus, unlike with entity purchase in the corporate setting, there is a great deal of flexibility within the partnership setting as it is possible to have a reduced number of policies with the entity purchase and still achieve an increase in basis for the survivors.

STRATEGY — ENTITY (STOCK REDEMPTION) PLAN

At Inception

In the Event of the Death or Disability of Owner A

The Benefits and Tax Considerations of a Entity Purchase Arrangement

View The Benefits Chart

View the Tax Considerations Chart

Cross-Purchase Arrangement

In a cross-purchase arrangement, the stockholders own insurance on each other and buy out the shares of the deceased partner. If more than two stockholders are involved, a cross-purchase arrangement may be cumbersome due to the number of policies required. The entity can pay the premiums for the life insurance used to fund a cross-purchase arrangement. If the premiums are paid as compensation, the corporation can take a deduction. If treated as dividends, the corporation cannot take a deduction. Discrepancies in age and stock ownership may create problems; in many cases, the payment of bonuses or other adjustments in compensation can reconcile an unbalanced allocation of cost.

A purchasing stockholder can increase his or her basis in the stock acquired under a cross-purchase agreement because he or she pays for the shares personally. An increased basis is important to the stockholder who anticipates a possible sale or gift of the stock at some point in his or her lifetime.

Strategy - Cross-Purchase Arrangement

At Inception

In the Event of the Death or Disability of Owner A

The Benefits and Tax Considerations of a Cross-Purchase Arrangement

View The Benefits Chart

View The Tax Considerations

Detailed Comparisons 

ENTITY VS. CROSS-PURCHASE ARRANGEMENTS — HOW THEY COMPARE

Additional Strategies

Trusteed Cross-Purchase Arrangement

A trusteed cross-purchase arrangement is a legal agreement between a third party and the stockholders that provides for the planned disposition at an agreed upon price of their ownership interests in the event of a death, disability, or retirement. The trustee acts to carry out the obligations of the stockholders.

A Trusteed Cross-Purchase Arrangement and Life Insurance Funding

To fund a cross-purchase arrangement with life insurance requires each shareholder to own a policy on every other shareholder. For example, this means that six policies would be required to fund a cross-purchase buy-sell involving three shareholders. The formula for calculating the required number of policies is the number of shareholders times that number minus one (x times x- 1). The need for so many policies is a major disadvantage of the cross-purchase approach whenever there are more than two or three shareholders involved.

In a trusteed arrangement, the shareholders establish a revocable trust naming an impartial third party as trustee. The trustee is the owner and beneficiary of one policy on the life of each shareholder. This reduces the number of policies needed. On the death of a shareholder, the trustee is obligated to collect the insurance proceeds and distribute them to the surviving shareholders as beneficiaries of the revocable trust. The shareholders then have the funds to purchase the stock of the deceased shareholder, required by a separate cross-purchase buy-sell agreement. The trustee will then distribute the deceased shareholder’s shares equally to the surviving shareholders.

The agreement may provide that the trustee collects the premiums from the insureds. Each shareholder insured would contribute funds to the trust, which would allow the trustee to pay the premiums as they come due. Alternatively, the business can pay the premiums and treat those payments as bonuses (tax deductible assuming no reasonable compensation problems exist). The premiums on each policy are treated as income to the shareholders other than the insured (since the insurance proceeds are for the benefit of the shareholders other than the insured).

There are disadvantages to consider when using a trusteed cross-purchase arrangement. Possible transfer-for-value⁶ issues may exist. For example, assume A, B, C, and D are equal stockholders in a corporation with a funded trusteed cross-purchase agreement. Under the arrangement, each stockholder is the beneficial owner of a one-half interest in the policies insuring the other three stockholders. Now assume that A dies. A prohibited transfer-for-value could occur if A’s proportional interest in the outstanding policies insuring B, C, and D pass to the surviving stockholders upon A’s death. At the next death, a portion or all the death benefit may now be income taxable unless an exception to the transfer-for-value rule is found.

⁶ Certain transfers of life insurance contracts may jeopardize the income tax-free payment of the death proceeds (above basis in the contract). You should always consult their tax and legal advisors prior to making any changes to ensure that the transfer either is not a transfer-for-value or meets one of the exceptions to the transfer-for-value rule and thus the death benefit will still be received income tax free.

Wait-and-See Buy-Sell Arrangement

The wait-and-see buy-sell arrangement is a hybrid buy-sell arrangement that combines elements of the traditional entity purchase and the cross-purchase buy-sell arrangements. Unlike those, the specific purchaser of an owner’s business interest remains uncertain until death, retirement, or disability actually occurs. This provides the business owner with flexibility as to the transfer of ownership when the triggering event occurs.

The wait-and-see buy-sell arrangement provides that the business entity has the first right to purchase the ownership interest in question after the triggering event, then the other owners have the right to purchase, and if any ownership interests remain, then the business entity must purchase the remaining ownership interests.

How the Wait-and-See Buy-Sell Arrangement Works

Let’s assume that we have three shareholders: Tom, Steve, and Mary. In the typical wait-and-see buy-sell arrangement this would be the situation at Tom’s death:

• The business would have a first option to buy Tom’s stock from his estate.
• Should the business fail to exercise this option, or exercise it only with respect to a portion of Tom’s stock, then Steve and Mary would have a second option to buy his stock (or the remainder of it).
• If Steve and Mary should leave any of Tom’s stock unpurchased, then the business, as the third option, must purchase any remaining portion (or all) of his stock. This assures Tom’s family that all of the stock will be purchased, and assures the surviving shareholders that they will succeed in having full control of the business.

Using Life Insurance to Fund the Arrangement

Each of the individual owners and the business entity are potential life insurance buyers. The entity has the greatest exposure since it has a binding obligation to purchase the interest if the two options are unexercised, or incompletely exercised. It is essential to establish the life insurance ownership in the proper manner at the outset. For this purpose, either the cross-purchase approach or the stock redemption approach may be used. However, more often the wait-and-see buy-sell is funded under the cross-purchase structure. This is because it is generally more tax efficient to move the insurance proceeds from the surviving shareholder(s) to the business (if the entity option was elected) than to move the proceeds from the business to the surviving shareholder(s) (if the surviving shareholder option was elected).

The wait-and-see buy-sell arrangement may not be appropriate in all circumstances. This approach is obviously not appropriate for a sole proprietorship or a single-owner corporation. Further, if the owners are related, the family attribution rules are a potential problem in the event of a redemption under the first option, or a mandatory purchase under the third step.

Factors to Consider in Determining the Form of Buy-Sell Arrangement

The decision to establish an entity or cross-purchase arrangement may require several factors to be weighed. This chart may provide some additional insight.

View Chart

Planning in the Event of the Owner’s Disability

You and Your Business Partners are Team. What if a Disability Took one of you out of the Picture?

The benefits of a well-crafted and appropriately funded buy-sell arrangement, as triggered upon the death of a business owner are generally recognized and appreciated. Unfortunately, many business owners who are concerned about selling their business interest upon death are not as concerned about selling their business interest if they become totally disabled. This mind-set is unfortunate because the problems, with respect to the disposition of a business interest, can be as detrimental upon total disability as they are upon the business owner’s death.

Preserve your Business’ Future

The total disability of a business owner places the owner in the unenviable position of having to maintain an interest in the business while the owner is physically or mentally disabled. This can create a severe strain for all the parties who are involved in the business.

• First, the owner who is disabled obviously must struggle with two burdens at once — the disability and the business. As a result, the financial burden created by the disability requires protection of both family income and daily business operation expenses, not to mention the possibility of a sale of the disabled owner’s interest in the business.
• Second, the family of the disabled owner must witness what they believe is an unnecessary struggle.
• Third, the business associates of the disabled owner may feel that the business should not have to operate without able-bodied management.
• Finally, both the creditors and the customers of the business may experience an unsatisfactory change in the policies and practices of the business after the owner becomes disabled. Thus, all of those involved in the business may be adversely impacted if the disabled owner of a business interest attempts to stay with the business notwithstanding the incapacity.

A Possible Solution

To help minimize undesirable consequences, a buy-sell arrangement that includes a disability buy-out provision with terms similar to the purchase of the business interest at death may be used. Of course, there are circumstances existing upon the disability of the business owner which may not be present at the owner’s death. However, these differences should not obscure the advisability of including disability buy-out provisions in the agreement. As part of the agreement, the purchaser or purchasers should agree to buy, and the business owner should agree to sell the interest in the business if the business owner becomes totally disabled. There are several factors to consider in preparing for the potential disability of a business owner:

• The arrangements required to purchase a disabled owner’s interest.
• The definition of disability for this purpose.
• The length of time the owner must be disabled before the buy-out is triggered.
• Whether the buy-out is mandatory or optional, and how the agreement is to be enforced.
• With respect to the business interest itself, how its value will be determined and by whom, and when (at the time of disability or later when the buy-out triggers).
• Whether the purchase price is fair and reasonable.
• Whether the buy-out is made in a lump sum or under an installment sale.

In a disability buy-out agreement, the parties should be clearly identified with their obligations to buy and sell in the event of an owner’s disability. Also, the price or the method of establishing the price should be specifically set forth. Funding the buy-out with a disability income insurance policy should help ensure that money will be available to execute the purchase (subject only to the insurer’s ability to meet its financial obligations, all premiums being paid when due, etc.).

A disability buy-out arrangement is specifically designed to help buy out the business interest of an active owner who becomes totally disabled. The potential conflict between the active owners and the disabled owner may be avoided if they enter into a properly drawn disability buy-out agreement and fund it appropriately. Such an agreement provides for the acquisition of the disabled owner’s share by the surviving business associates and for the payment to the disabled owner of an agreed upon price for the business interest.

Protect the Business and the Family

As with any buy-sell arrangement, the buy-out of a disabled owner’s interest can occur in one of three ways — by an entity agreement where the business itself buys back the interest, by a cross-purchase agreement where the remaining owners buy the disabled person’s interest, or by a trusteed cross-purchase agreement.

There are three basic forms of DI buy-sell agreements:

1. Entity Agreement: An entity purchase buy-sell agreement is a legal agreement between a business entity and its owners. To illustrate how it works, assume a business is owned equally by A and B. They each enter into an agreement with the business for the purchase and sale of their respective interests. Typically, the agreement is binding, in that it obligates both A and B, and their estates to sell, and the business to buy, upon the disability of either one of them.

   The agreement establishes a value of the business interest to be bought. In the event of an owner’s disability, the agreement typically provides for the transfer of the ownership interest in exchange for cash or cash and an installment note. Once the departing owner receives the cash, the business interest is transferred to the business.

2. Cross-Purchase Agreement: A cross-purchase buy-sell agreement is a legal agreement among the owners that provides for the planned disposition of their interests in the event of a disability. To illustrate how this works, assume a business is equally owned by two individuals, A and B. They enter into an agreement providing for the purchase and sale of their respective interests. Typically, this agreement is binding and obligates both parties, or their representatives, to either buy or sell upon the disability of either one of them.

   There may be situations in which an entity purchase agreement could be preferable even with two or three owners. For example, where the oldest owner has the largest interest in the business, a cross-purchase agreement would require the younger owner, usually lower-paid, to make the larger premium commitment. An entity purchase agreement would pool the premium burden and be easier on the younger owner.

3. Trusteed Purchase Agreement: A trusteed cross-purchase agreement is a legal agreement between a third-party trustee and the partners or stockholders that provides for the planned disposition of their ownership interests in the event of a death, disability, or retirement. The trustee or escrow agent acts to carry out the obligations of the partners or shareholders.

Why a Buy-Out is Funded with DI Insurance

The same rationale for using a life insurance policy to fund a buy-sell obligation upon the death of a business owner applies to using a disability policy to fund a buy-out obligation upon the total disability of a business owner. Admittedly, depending on the value and the cash position of the business, it may be possible to use current cash or borrowed funds to help purchase the disabled owner’s business interest. However, from a simple economic point of view, using current cash is often an expensive way to purchase a business interest. Even if the business has sufficient capital, insurance may still be the best way to fund the buy-out. Because the purchase of a business interest is not a deductible expense, after-tax dollars are needed. For example, in a 25% tax bracket, it takes $133,333 before-tax dollars to leave $100,000 after taxes.

Premiums for disability buy-out (DBO) insurance are a non-deductible expense. The benefits, however, are generally received income tax free² and can be used for the business purchase. Upon the disability of an owner, the business may be obligated to continue to carry the disabled owner and pay salary and benefits for an indefinite period of time. In addition, the disabled owner is often still entitled to a share of profits and maintains his or her share of the overall business. The DBO insurance policy provides a means to buy the interest of a disabled owner, generally over a period of years, once it is evident the disabled owner is not going to return. The payment can be a monthly amount or a lump sum.

Important Factors To Consider

What is the Definition of Disability?

The concept of “disability” as it relates to an owner’s active participation in a business is often far more difficult to define and describe than are most other buy-sell triggering events. Setting forth the conditions under which an individual is deemed to be disabled is essential to a successful arrangement.

An injury or sickness may leave a person unable to work for days, months, years, or for the rest of his or her life.

Basically, when an active business owner is disabled for a period in excess of one year (more or less, depending on the business), the disability, whether “temporary” or “permanent” for medical purposes, will affect the business as if it were permanent.

Business considerations will usually dictate the replacement of an unproductive and disabled individual; meanwhile, the disabled owner needs the assurance that he or she will receive fair payment for his or her business interest. A disability buy-out arrangement funded with disability income insurance can be a logical solution.

The success of a disability buy-out arrangement may be largely dependent on the insurance used to fund it. Thus, the most logical definition of disability to use in the agreement is likely to be the definition contained in the insurance policy that will fund the buy-out. This places upon the insurance company the burden of determining whether the owner’s disability meets the policy’s definition, thus avoiding potential disagreements among the owners.

Policies may define total disability as the inability to perform the duties of the insured’s regular occupation or a reasonable occupation based on the insured’s education, training, or experience. The individual’s ability to contribute in a meaningful way to the business is what you want to insure for the purposes of a disability buy-sell arrangement. Even if the owner can work in a different, unrelated business, he or she will want to continue to be deemed totally disabled for purposes of the buy-out and coverage under the policy because of his or her inability to work in the former business.

⁷ It is possible to achieve an increase in basis for S Corporation surviving stockholders with a stock redemption plan if the corporation uses cash basis accounting. This is done by the survivors electing a short fiscal year when a stockholder dies. IRC § 1377, 1367(a).

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