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If you own all or part of a business, you should know about buy-sell agreements.
They help provide for the orderly transfer of a business if something unfortunate or unexpected happens. That can provide peace of mind for any business owner.
What is a buy-sell agreement?
A buy-sell agreement is a legally binding agreement that requires one party to sell, and another party to buy a particular ownership interest in a business.
A business buy-sell agreement — also sometimes called a business buyout agreement or business continuation agreement — can be designed to protect the enterprise from certain triggering events. The most common of such events are often referred to as the five D’s:
- Death
- Disability
- Divorce
- Departure (either voluntary or involuntary)
- Disqualification (pertains to malfeasance that would require an individual to be removed from an ownership position).
Obviously, any the five D’s can and will happen at any time. So, it’s important to plan for them with a buy-sell agreement. And keep in mind, a buy-sell agreement is distinct from key person insurance, which protects the business from the financial impact of losing a critical employee rather than addressing ownership transfer. (Related: Key employee insurance: What it is and does your business need it?)
Establishing the buy-sell agreement should be supervised and executed by an attorney. The structure of the buy-sell agreement can vary, and the owners of a company, with guidance from their legal and financial professionals, can determine which structure best fits their needs.
The two most common types of buy-sell agreements are entity-purchase and cross-purchase agreements. (Related: Funding a business buy-sell agreement)
Entity-purchase agreements
Under an entity-purchase plan, the business purchases an owner’s entire interest at an agreed-upon price if and when a triggering event occurs.
· If the business is a corporation, the plan is referred to as a stock redemption agreement.
· In the context of a partnership, it is called a liquidation of interest.
If life or disability insurance is used to fund the agreement, the business owns and is the beneficiary of insurance on the lives of each stockholder and then uses the proceeds to purchase (redeem) their stock at death or disability. This plan can be relatively straightforward as the business is the owner, premium payer, and beneficiary of the policies. If whole life insurance with cash value is used as part of the agreement, the cash value is recorded as an asset of the business on the balance sheet.
It is important to note that, depending on the structure of the corporation, there are different tax implications to consider when using an entity-purchase plan.
Indeed, the Supreme Court in 2024 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. (Learn more: Business owners: Check your buy-sell agreement)
Cross-purchase agreements
The use of a cross-purchase plan for a corporation requires each stockholder to purchase and own life insurance on the lives of the other stockholders. Each owner would pay the premiums and be the beneficiary of the policy. The face amount of the insurance would be calculated based on the other’s ownership interest.
Upon the death of one owner, the insurance proceeds would be used to purchase the ownership interests from the deceased owner’s estate or family.
This plan may become too cumbersome if there are more than two stockholders. In this situation, the owners could use a "trusteed" cross-purchase arrangement. Here, a trust would own one policy on each stockholder and represent the others in the transaction, eventually distributing the deceased shareholder’s stock to the remaining stockholders. Disability buy-sell insurance can also be used in a cross-purchase agreement to facilitate transfer of ownership upon the total disability of a stockholder.
Whether your plan is structured as an entity-, cross-, or trusteed cross-purchase agreement, the taxation of premiums and benefits are the same. The premiums paid are not tax deductible, but the benefits are generally received income tax free.
Another choice
Another option also has been growing in popularity. The hybrid (or 'wait-and-see') agreement gives the business the first option to buy a departing owner's interest or portion of that interest, with the remaining owners having the option to step in if the business declines.
This maximizes flexibility for the company and the remaining owners by deciding who buys the departing owner's shares based on the financial and tax circumstances at the time of the exit. This has become particularly important in the wake of the Supreme Court decision mentioned above.
Typically, with such an agreement, if neither the business nor the remaining owners purchase the full stake, the agreement requires the business to redeem whatever is left over to ensure a complete buyout.
Sole owner choice
What if there aren’t co-owners? Then the one-way buy-sell type of agreement comes into play. It can be used when there is a sole owner of a business and there are no co-owners to buy out the owner’s interest when a triggering event, such as death or retirement, occurs. If a potential buyer of the business can be identified, perhaps a family member or a key employee, this version of the buy-sell agreement can be adapted for the sole-owner situation.
It is called the “one-way” buy-sell because only one party (a non-owner) is obligated to purchase the business when a triggering event occurs. The benefit of using a one-way buy-sell is it allows the sole owner to exit the business and still receive fair market value for the business from another party looking to assume ownership in the future.
Protect what you have built
You have built your business with the hopes that it will withstand the test of time. Unfortunately, there are a lot of elements out of your control that can affect the success of your business such as death or disability. It is possible to plan for these contingencies and ensure that both your business and the well-being of your family are able to survive an unforeseen event. (Related: Which buy-sell agreement is right for you?)
Since 1851, MassMutual has been focused on helping people secure their financial future and protect the ones they love. That mission is why we have thousands of financial professionals to assist you on your business plans. You can let us know you’d like to talk to one and we’ll have one of our financial professionals contact you.
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Frequently Asked Questions about buy-sell agreements
Q. What is a buy-sell agreement?
A. A buy-sell agreement is a legally binding contract that requires one party to sell and another to buy a particular ownership interest in a business when certain triggering events occur. It helps ensure an orderly transfer of ownership and provides peace of mind for business owners.
Q. What are the five D's in a buy-sell agreement?
A. The five D's are death, disability, divorce, departure (voluntary or involuntary), and disqualification (malfeasance requiring removal from ownership). These are the most common triggering events that a buy-sell agreement is designed to address.
Q. What is the difference between an entity-purchase and cross-purchase agreement?
A. In an entity-purchase agreement, the business itself buys the departing owner's interest, while in a cross-purchase agreement, the remaining owners individually buy it. Entity-purchase is simpler to administer, but cross-purchase can offer tax advantages for surviving owners.
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This article was originally published in March 2016. It has been updated.
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Insurance products issued by Massachusetts Mutual Life Insurance Company (MassMutual) Springfield, MA 01111-0001 and its subsidiaries C.M. Life Insurance Company and MML Bay State Life Insurance Company, Enfield, CT 06082.
