Business owners: Which buy-sell arrangement is right for you?

This article will ... Describe the most common types of buy and sell arrangements. Discuss the advantages each type may have for your business.  Note how each could present challenges, depending on your business circumstances.

There are several types of buy and sell arrangements, each with its own advantages and disadvantages. Ultimately, all are methods to plan for the orderly transition of a business after a triggering event, such as the retirement, death, or disability, of one of the owners.

The type you’ll choose is largely based on the form of your business organization (e.g., sole proprietorship, partnership, S corporation or LLC) and the number of owners or stockholders.

Here’s a quick description of the most common types of arrangements.

• The Cross-Purchase Arrangement
• The Entity Purchase aka Stock Redemption Arrangement
• One-Way Buy-Sell Arrangement

Here is a closer look at each.

The Cross-Purchase Arrangement

This arrangement is between two or more co-owners, each of whom agrees to purchase the interest of the other(s) after a triggering event.

The purchase is typically funded with life insurance. Each co-owner buys a life insurance policy on the other(s) and is also the policy beneficiary. Either a death benefit or a loan from the policy’s cash value ¹ provides the necessary funds.

· The Advantages

If the death of an owner is the triggering event, then the proceeds pass directly to the other owner(s) tax free. They also receive a step-up in tax basis that will reduce their income taxes if and when they eventually sell their shares.

The life insurance proceeds go to the individual owner(s) and aren’t subject to claims of corporate creditors.

· The Disadvantages

If there are multiple owners, then there are multiple life insurance policies that can be costly and difficult to administer.

Each business owner must meet the underwriting requirements for their specific life insurance policy coverage.

There may also be a big difference in the premiums each owner pays due to significant differences in the ages and health of the others.

The Entity Purchase (aka Stock Redemption Arrangement)

Here, it’s the company that agrees to redeem the shares of an owner after a triggering event. To fund the purchase, the business buys life insurance on all of the owners, pays the premiums, and is the beneficiary.

· The Advantages

This simplifies matters when there are a number of owners and number of policies. The corporation owns only one policy per owner.

The business absorbs any disparities in premiums so younger, healthier owners don’t have to.

· The Disadvantages

There’s no step-up in basis for the owners of the business. After a triggering event, the remaining owners will pay capital gains tax on a large sum if they exit the business before they die.

Each business owner must meet the underwriting requirements for their specific life insurance policy coverage. The proceeds from the insurance may force the company to issue a dividend or pay a retained earnings tax.

Also, the Supreme Court recently ruled that life insurance proceeds received by a corporation to cover the repurchase of the deceased shareholder’s stock interest must be included in the value of the corporation for federal estate tax purposes. Those proceeds are not offset by the corporation’s obligation to repurchase the deceased shareholder’s stock. (Related: Business owners: Check your buy-sell agreement)

One-Way Buy-Sell Arrangement

If you’re a sole proprietor or have a single shareholder corporation, a One-Way Buy-Sell Arrangement can be designed to provide the business owner with a willing buyer in the event of retirement, disability, or death. This will typically be a key employee, another business entity in a related market or industry, or a family member that you want to inherit and continue managing the business.

Conclusion

The legal complexity and tax consequences of buy-sell arrangements means you’ll need professional advice to select and structure an appropriate agreement.

Seek the advice of an attorney, tax adviser, and financial professional.

• MassMutual financial professionals have helped thousands of business owners with their business transfer needs. You can count on us to answer your questions.
• Contact your MassMutual financial professional today.

Discover more from MassMutual ...

Funding a buy-sell agreement

How to sell or transfer a business

Your business and the odds of liquidation

_______________________