Do you own a business? Do you have a will for your business?
Sole proprietorships, partnerships and small closed corporations all need to consider what happens if the owner or one of the partners or shareholders dies or becomes disabled.
Who will purchase the company or the deceased partner’s or shareholder’s interest? What is a fair price? When will the sale be made? Will the deceased owner’s/partner’s/shareholder’s families be given a fair share and be taken care of?
These are real questions every small business should deal with before the event occurs.
A buy-out sell agreement is a will for a business; It secures the wishes & expectations of the deceased as well as eliminating any misunderstandings and/or possible heartache in the event of the death of an executive member of the business. A defined plan needs to be in place and a method of funding for that plan must also be available.
When a personal death happens in the business world , The perception by the creditor’s or suppliers may change or be influenced. Concerns of the value of the deceased employee to the success of the business may arise. Key employees may consider the deceased’s death as a reason to move elsewhere. The need for continuity and smooth transitions in the business when tragic events such as deaths or disabilities occur is a necessity. The buy-sell agreement is important to resolve the concerns or problems that result from the emotional turmoil of the employees, creditors, suppliers and the deceased person’s family.
There are several options for business owners to fund a buy-sell agreement:
- Borrowing Funds – obviously, borrowing funds is not an option to a dead sole proprietor. Could a key employee put together the money to purchase the company? Can the surviving partner(s) borrow enough to purchase the assets of the deceased partner? Maybe they can take out a second mortgage on the house? Maybe the lost one is the one depended upon by bankers and suppliers. Maybe the repayment and interest is simply too burdensome.
- A savings account can be set up within the company in anticipation of an event like this happening. However, if you are a corporation there may be accumulated earnings tax problems. If you are not a corporation, it may be difficult to maintain any savings in the account, or the death may occur prematurely before enough funds are available.
- You could purchase life insurance.
- Or you can just sit back to wait and see what happens
“I’ll worry about that if and when it happens.” A sole proprietor can say, “I’ll be dead, so no reason for me to worry about it.” If it is a partnership, the partnership dissolves automatically and, “My partner will do the right thing.”
Is that a risk you are willing to take with your company? Of course you can use your personal funds to buy-out your partner’s stock; But what happens if the death comes at a bad time? What happens if your personal stock portfolio is down and you’ve had to take less income from the business lately because business has been in a slump? What will happen to you business then? Maybe, after a lengthy probate a corporation will buy the stock and turn it into treasury stock, but still that is only “if” funds are available.
Furthermore, where does this leave the family of the deceased? Would you leave it up to your partners to do the right thing for your family no matter what the personal cost would be to the partner?
Let’s take a look at this from different perspectives:
A Sole Proprietor
Unless a sole proprietor has a family member or a close relative to turn the business over to and feels comfortable that the owner’s desires for his/her family members will be served, the options are limited. The business can be closed, it can be sold to an outsider, although small businesses are sometimes difficult to sell, or by the owners request it can be sold to his employees to keep the business running.
The buy-sell agreement to a trusted employee becomes a two-step plan:
An agreement is prepared which sets forth the employee’s obligation to buy, the price the employee(s) will pay for the business and the method of payment
The employee takes out a life insurance policy on the owner. The employee is the owner of the policy, the person who pays the premiums and the beneficiary.
If the owner dies, the death benefits of the insurance policy would be used to buy the business from the owner’s estate.
Partnerships are automatically dissolved with the death of a partner; A buy-sell agreement is very important. In this case, a buy-sell agreement would sell the deceased’s interest in the company to the surviving partner(s) at an agreed to price.
For partnerships there are two different plans:
- Cross-Purchase Plan – in this plan each partner buys a life insurance policy on each of the other partners. The partnership itself is not a participant in the agreement. Each partner owns, pays the premium payments and is the beneficiary of the insurance policies on the other partners in an amount equal to his share of the purchase price set forth in the buy-sell agreement. The proceeds are used to purchase the partner’s business interest from the heir’s of the deceased.
The number of policies required for a partnership with multiple partners would be the number of partners X (number of partners-1). For example, a plan for a partnership with three partners would require six separate insurance policies. Each partner would need a policy on each of the other parties.
Let’s say a business worth $600,000 is owned by three partners in equal shares. Each partnership would be worth $200,000 and if one of the partners died, the other two partners would have to provide $100,000 each to equally purchase the deceased person’s share. Therefore, each partner, in this case, would take out a policy on each of the other two partners in the amount of $100,000 each.
- Entity Plan – in this plan partners enter into an agreement with the partnership who owns, pays the premium payments and is the beneficiary of the policies. When a partner dies, his/her interest is purchased from his/her estate by the partnership at the buy-sell agreement price and the interest is then divided among the surviving partners in proportion to their own interest.
In this case, the $600,000 business discussed above would purchase a $200,000 policy for each of the three partners. If one of the partners dies, the business pays the deceased partner’s share from the death benefit of the policy and distributes those shares equally to the two remaining partners. The remaining partners, in this case, would then each own 50% of the business.
Because of origination funding, buy-ins, etc., not all partnerships are owned equally by the partners. In those cases, both the insurance policy’s amounts and the benefits distributions would be made on the basis of each partner’s proportionate share in the business.
Additionally, none of the premium payments in the above plans are tax deductible; however, the benefits are tax-free.
Unlike a partnership, a closed corporation (i.e. a small number of shareholders who run the business) does not cease to exist with the death of one of its shareholders. For closed corporations, there are also two different plans:
Cross-purchase plan – each stockholder owns, pays for and is the beneficiary of life insurance on the other stockholders in amounts equivalent to his or her share of the purchase price. The corporation is not a party to the agreement. The surviving stockholders purchase the interest of the deceased stockholder as individuals from the estate of the deceased stockholder. This plan is like the cross-purchase plan described in the partnership section above. Obviously, the more shareholders the more difficult this plan becomes.
Stock redemption plan – the corporation, rather than the stockholders, purchases the insurance policy, pays the insurance premiums and is the beneficiary on the lives of each shareholder. The amount of insurance on each stockholder is equal to the proportionate share of the purchase price. Upon the death of one of the stockholders, the death benefits are paid to the corporation who then buys the deceased’s stock from the deceased’s estate. Premiums are not taxed deductible but the proceeds are received income tax free.
Any agreements and insurance policies within a business must be integrated with the overall plan and objectives of the business. Careful consideration must be given to the selection of the plan which is right for your business and to the method of funding your plan.
If you are interested in applying for Buy-Sell Agreement, or would like more information, please contact our office at (301) 590-0006.