Entrepreneurs are the back-bone of America. They are an incredibly hard-working group and much of the wealth in this country has been created by their efforts. Partners and family members may be involved in helping run the business. If a key entrepreneur leaves the business because of divorce (even from each other), death, retirement, or disability; he and everyone else involved are virtually risking all that is so important to them… the business itself and their family’s well-being. A buy/sell agreement can help.
A buy/sell agreement is a pre-planned agreement for the business owner to sell and someone else to buy some or all of the business upon the occurrence of some specific event, typically a business owner or partner’s death, divorce, retirement or disability. It can be used by any type of business: sole proprietor, partnership, corporation, even an LLC. But, it must be structured as an arms-length transaction which provides for a fair price to be paid. This allows the owner to plan his estate and reduces the risk of costly valuation disputes between the parties later or upon IRS audit. To be most effective, however, the buy/sell agreement must include a plan to provide the buyer with the cash to pay for the purchase when the time comes.
Life insurance and disability insurance are most often used to fund a buy/sell agreement in the event of the owner’s death or disability. A cash value life insurance policy can be used to provide cash to the buyer in the event of the owner’s retirement. The buy/sell agreement itself may provide for either a single lump sum payment, installment payments or any combination of the two.
There are two basic forms of buy/sell agreement: the cross-purchase and the entity purchase agreement. The cross-purchase agreement provides for the owners to buy out each other at a specific time such as attaining a specificized retirement age, death, disability, or if an owner’s spouse files for divorce. To fund the agreement, each owner can buy a cash value life insurance policy on the life of the other. When the triggering event happens, the policy proceeds are used to complete the buyout.
The entity purchase agreement, or “redemption” agreement, works a little differently. It is usually used when there are more than two owners or the cross-purchase has become too difficult or costly to fund. It can also be designed to take advantage of favorable estate capital gains tax rules (Sec. 303). With an entity purchase agreement, each of the owners makes an agreement with the business itself. When insurance is purchased to fund the agreements, the business will own the policies and this may reduce the number of policies needed.
The buy/sell agreement ensures the continuance of the business the entrepreneur worked so hard to create. That makes life easier for family members and other owners that remain in the business. It also ensures that entrepreneur and his family realize the maximum benefit for all of his hard work.
Of course, this is a brief article and careful consideration should be given to all advantages and disadvantages of a buy/sell as it applies to your particular business and personal situation before implementing the strategy. Consult with your tax advisor, attorney or financial advisor before you implement any significant tax or financial planning strategy.
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