Anyone who owns a closely held business with at least one other partner needs to take certain steps to guard against business disruption. If one partner departs suddenly, or becomes disabled or dies, serious confusion and conflicts can ensue. Among the most important steps is to create a buy-sell agreement which stipulates precisely how ownership interests will be valued and purchased.
Two ways to play
In most situations, payouts for a buy-sell agreement are funded with a cash-value life insurance policy or a disability buyout insurance policy. There are two main types of life insurance-funded buy-sell agreements:
- In a cross-purchase agreement, partners buy insurance policies on each other, using the proceeds to buy a deceased or disabled partner's ownership shares. They receive a step-up in cost basis that may reduce taxes if the business is later sold. This option is usually preferable if there are three or fewer business partners.
- In an entity-purchase agreement, the business entity buys insurance policies on each partner and uses the proceeds to buy a deceased or disabled owner's shares, which are then divided among the surviving partners. Partners receive no step-up in cost basis with this type of agreement. This option is usually preferable if there are four or more partners because it eliminates the need for each partner to buy so many insurance policies. We have seen clients use a form of trust to hold the insurance and eliminate the need for multiple policies.
It's usually wise to hire a professional business appraiser to perform a business valuation when drafting a buy-sell agreement. The valuation should then be updated periodically as circumstances that could potentially affect the value of the company change. In fact, the buy-sell agreement itself should be reviewed by all of the partners from time to time to make sure it still reflects each partner's intentions.
An important step
Creating a buy-sell agreement is an important step in the growth and preservation of every business. For help creating or reviewing yours, give our business advisory team a call.