A buy-sell agreement is a legally-binding agreement that prepares for the future sale of a business or the purchase of a co-owners interest in the event a number of different situations including, if one co-owner dies, is forced to leave the business, or chooses to leave.
The 3 types of buy-sell agreements are:
1. Entity Buy-Sell
The business enters into a written agreement with the owners to purchase the interest of each owner in the event of disability, death, divorce or departure of a co-owner.
2. Cross-Purchase Buy-Sell Agreement
Individual owners agree to purchase the interest of other owners. Each individual is the owner and beneficiary of a life insurance policy on each of the other owners, and the policy proceeds are used to pay the purchase price.
3. Partnership Administration Succession Strategy (PASS)
Individual owners for a separate partnership and the partnership acquire life insurance policies on all the owner and administers the provisions of the buy-sell agreement. This approach has numerous tax and financial advantages compared to traditional stock redemption or cross-purchase agreements particularly in the case of C or S corporations with more than two owners.
Buy-Sell Agreements Comparison
| Cross-Purchase Buy-Sell | Redemption Buy-Sell | |
| Parties to the plan | The plan is between the owners. | The plan is between the business and its owners. |
| Income tax treatment by surviving business owners | Purchasing business owners get a new basis in acquired ownership interest. | Survivors own a larger percentage of the business, but the basis in the interest does not change. |
| State law restricting redemptions | N/A | State law may require redemptions to be made from surplus only. |
| Family attribution rules. (IRC Section 318) | N/A | These rules may cause what appears to be a total redemption of a decedent’s stock to be treated as a taxable dividend. |
| Availability of life insurance policies to business creditors | Not usually. If creditors are able to “pierce the corporate veil,” policies may be available to them. | Cash values and proceeds are generally available to the creditors of a business. |
| Premium payer | Business owners. If the business pays, it must be treated as additional compensation. | The business. It is the owner, beneficiary, and premium payer. |
| Transfer for value issues | A purchase of policies by a surviving owner creates a transfer for value. This will cause proceeds to be partially subject to income taxation unless the surviving owner is the insured. | Since policies are owned by the business there is no need to make a transfer when an owner dies. |
| Complexity | At death, there may be multiple buyers of the decedent’s business interest. In an insured plan, this also means multiple policies on each owner. | At death, there is only one buyer (the business) and one seller (the deceased owner’s estate). |
| Number of policies required | May require many policies. The formula is: Number of owners multiplied by numbers of owners – 1. For example, if there are 5 owners, you need 20 life insurance policies: 5 x (5-1). | Requires only one policy for each owner. |
| Other considerations | 1. If an owner is having trouble paying premium, the policy may lapse.
2. The cost of the plan may be higher if the business is in a lower tax bracket than the individual. 3. Voting power may be altered in an undesirable way. |
1. It permits pooling of premium obligations
2. “Unreasonable compensation” questions do not arise. This issue arises when salaries are increased to pay premiums for life insurance used to fund cross-purchase agreement. 3. Life Insurance proceeds are included in adjusted current earnings for purposes of corporate alternative minimum tax. |
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