If you own an interest in a closely held business, it’s critical to have a well-designed, properly funded buy-sell agreement. Without one, an owner’s death can have a negative effect on the surviving owners.
If one of your co-owners dies, for example, you may be forced to go into business with his or her family or other heirs. And if you die, your family’s financial security may depend on your co-owners’ ability to continue operating the business successfully.
There’s also the question of estate taxes. With the federal gift and estate tax exemption currently at $5.34 million, estate taxes affect fewer people than they once did. But estate taxes can bring about a forced sale of the business if your estate is large enough and your family lacks liquid assets to satisfy the tax liability.
A buy-sell agreement requires (or permits) the company or the remaining owners to buy the interest of an owner who dies, becomes disabled, retires or otherwise leaves the business. It also establishes a valuation mechanism for setting the price and payment terms. In the case of death, the buyout typically is funded by life insurance, which provides a source of liquid funds to purchase the deceased owner’s shares and cover any estate taxes or other expenses.
There are two basic types of a buy-sell agreement: a redemption agreement, under which the business buys back a departing owner’s interest, and a cross-purchase agreement, under which the remaining owners buy the interest.
Depending on the structure of your business and other factors, the type of agreement you choose may have significant income tax implications. Your advisor can help you design a buy-sell agreement that’s right for your business.