Lets start with this very common scenario.
- You are Male, your partner is male and you are both married with children
- You are a part-owner of a small/medium business;
- You like your partner, but you feel that his wife is “eh” and more importantly his kids are brats who have no idea what it took to build this company; and finally
- Your Wife has no clue what you do on a daily basis
Sounds like a normal situation right? Well what the heck happens when one of you dies?!
- You die, and now your spouse owns some business (if you had a will). She has no idea what to do with, and can either be part owner with your partner or attempt to negotiate a sales price within months of your sudden death.
OR
- Your partner dies, and now you own your business with a woman you think is just “eh” and their kids who suck.
Would you be interested in an alternative scenario? Yeah, I thought20so! Well you want to look into a Buy-Sell.
Introduction to a Buy Sell Agreement
A buy-sell can take care of more than just death – it can defined what happens if someone becomes disabled, retirement, and sale. We are going to focus on death cause that is the easiest to understand, and well….it is final! There are 3 main types of Buy-Sell Agreements and then a bunch of variations that are way too advanced for the purpose of this post.
- Entity Purchase or Stock Redemption
- Cross Purchase
- Wait and See
We are going to take a high level view on each and just talk about some pros and cons of each situation. Before we get started, I am going to be using the word “buy” a few times….it is because we are talking about a BUY Sell Agreement! There are 2 main ways to accomplish this
- Sinking Fund – No Leverage and I am not really familiar with any business that is hording cash in the case a partner dies
- Insurance – Oh no the dirty word! You need cash for a buy-sell and insurance companies have it. I always recommend a permanent product because hopefully this is a permanent problem. What is 20 year term good for if your business lasts into the 21st year?
Entity Purchase or Stock Redemption Buy Sell Agreement
In this case when You or Partner dies the entity will buy back your shares. There are some simple/advanced advantages and disadvantages. If you are going to use insurance to leverage the buy back then that insurance is paid for by the business since it is the business that owns the policy. The insurance is notdeductible, but most CPAs incorrectly deduct it. The main advantage is that each partner only needs 1 life insurance policy, the main disadvantage is that the surviving partner does not generally get a step up in basis on the deceased partner’s shares when sold.
Cross Purchase Buy Sell Agreement
In this situation when you or your partner dies the heirs will be forced to sell those shares to the surviving partner. The main disadvantage of this set up is when there are more than 3 partners. Since every partner will need to own life insurance on each of his partners – the insurance can get mind numbing. So if we have 4 partners we will need 12 policies!!! There are advanced planning techniques to get around this, but at face value this is the main shortfall. The main benefit? You, as survivor, when you sell their shares later on – GET A STEP UP in basis for date of death value of when the partner died.
Wait and See Buy Sell Agreement
No picture necessary – you set up the agreement to let the surviving partner decide which of the two is going to happen. Usually it says something along the lines of – Company, as its own entity, gets first shot to buy…if it doesn’t then the surviving partner gets to buy it.
Conclusion
This topic is ripe with pot holes and speed bumps so be careful who you work with. I took some liberties with calling people – partners, shareholders, jumping back and forth with the words corporation, business, partnership, etc…THESE titles have real tax repercussions, so be careful when setting one up.
