When a business has two or more owners, the death of one partner raises an immediate question: what happens to their ownership interest?
Without a plan, the deceased partner's share may pass to their heirs - who may have no interest in running the business, or whose involvement the surviving partners do not want.
A buy-sell agreement answers the hardest question before it becomes a crisis: who owns the business when a partner dies?
What is a buy-sell agreement?
A buy-sell agreement is a legally binding contract between business co-owners. It establishes what happens to an owner's interest if they die, become disabled, or leave the business.
How life insurance funds the purchase
A buy-sell agreement is only as useful as the money available to fund it. Life insurance is one of the most common funding mechanisms because it can provide a large sum of money at the exact moment it is needed - when a partner dies.
Two partners each own 50% of a business valued at $1,000,000. They agree that if one dies, the other will buy out the deceased partner's share for $500,000. Each partner takes out a $500,000 life insurance policy on the other. When one partner dies, the surviving partner receives the $500,000 death benefit and uses it to purchase the deceased partner's share from their estate.
Cross-purchase vs. entity purchase
There are two main structures for a life insurance-funded buy-sell agreement.
In a cross-purchase arrangement, each partner owns a policy on the other partners. In an entity purchase (or stock redemption) arrangement, the business owns policies on each partner and buys back the interest directly. Each structure has different tax and administrative implications - especially when there are more than two partners.
Setting the purchase price
The buy-sell agreement must establish how the business will be valued. Common methods include a fixed price (agreed upon and updated periodically), a formula based on earnings or book value, or an independent appraisal at the time of the triggering event.
What happens without a funded agreement
Without a buy-sell agreement, the surviving partners may be forced to take on the deceased partner's heirs as co-owners, buy out the heirs without a pre-agreed price, or dissolve the business entirely.
Two partners build a landscaping company over 15 years. One dies without a buy-sell agreement. His 25% share passes to his spouse, who has no interest in the business but needs income. The surviving partner and the spouse cannot agree on a price. The business is eventually sold at a discount to resolve the dispute.
Start the conversation early
Buy-sell agreements are most effective when they are put in place before a triggering event occurs. The time to plan is when all partners are healthy and the business is running well.
A licensed insurance agent can help you understand the life insurance component. An attorney should draft the agreement itself, and a tax advisor can help structure it to minimize tax consequences.
This article provides general education. Buy-sell agreements involve legal and tax considerations. Consult a licensed attorney and tax advisor before entering into any agreement.