If you own a business with one or more other people, have you thought about what would happen if one of you died tomorrow?

An insured buy-sell agreement is a solution that allows your business to continue operating by providing a source of funds to compensate the deceased owner’s family for his or her share of the company, without having to liquidate company assets. The surviving owners rarely wish to become partners with a deceased owner’s heirs and the heirs rarely wish to get involved with the day-to-day operations of their loved one’s business. So, what exactly is a buy-sell agreement? Simply put, a buy-sell agreement is a legal contract that outlines the terms for the transfer of a deceased owner’s share of the company upon death. The purchase price is set out in the agreement so that there is no haggling over price or terms between the surviving owner(s) and the decedent’s family. Buy-sell agreements are generally funded using insurance policies on the lives of the owners and can be structured either as a cross-purchase agreement or a stock redemption agreement. The stock redemption agreement and cross-purchase agreement each have advantages and disadvantages for the owners to consider when deciding upon the best plan for their situation.

Cross-purchase agreements

The most common form of a buy-sell agreement for small and closely held companies is the cross-purchase agreement. Under a cross-purchase agreement, each owner of the company takes out and is the beneficiary of an insurance policy on the lives of each of the other owners. When an owner dies, the crosspurchase agreement requires the other owner(s) to use the insurance proceeds to purchase the deceased owner’s share of the business from the deceased owner’s heirs or other designated beneficiaries. These policies are paid for by each owner personally, and not by the company. A company may choose to reimburse the owners for the insurance premium payments, but such reimbursements are not deductible as business expenses by the company. Each owner should purchase a life insurance policy on the other owner(s) with a face amount equal to the agreed upon value of the insured owner’s share of the company.

Some of the advantages of cross-purchase agreements are as follows:

• Cross-purchase agreements are simple to set up.

• The transaction occurs outside the company, between the owners themselves. Accordingly, the life insurance policies and their proceeds are protected from the claims of the company’s creditors.

• The life insurance proceeds payable are not taxable to the beneficiary, and the deceased owner’s estate receives a stepped-up basis in the ownership interest being sold. Accordingly, there is no tax liability to the buying party or the selling party.

• Moreover, because the basis of the ownership interest acquired by the surviving owner(s) is equal to the fair market value of the ownership interest acquired, the surviving owner(s) overall basis in their ownership interest in the company is increased, resulting in a lower capital gain on any subsequent sale of stock. For example, assume that Owner A and Owner B each own a 50 percent interest in their company and each 50 percent interest is worth $500,000 with a basis of $100,000. Under a cross-purchase agreement, A and B each obtain life insurance policies with a face value of $500,000 on each other’s lives. If A dies first, her estate receives $500,000 from B, and B receives a 100 percent interest in the company, worth $1 million and a basis of $600,000.

• No risk that the life insurance proceeds will be added to the value of the company for purposes of valuing the deceased owner’s ownership interest for estate tax purposes.

Some of the disadvantages of cross-purchase agreements are as follows:

• If the business has several owners, the number of life insurance policies needed can be cumbersome, particularly if there are multiple life insurance policies that need to be reshuffled every time an owner dies. Aside from the complexity, the policy reshuffling itself may trigger income tax problems that could destroy the tax-free character of the life insurance death benefit.

• There is a potential for disparity in the cost for life insurance premiums on owners who are older or in poor health versus owners who are younger and in good health. For example, insurance premiums on the life of a 30-year-old owner will be cheaper than premiums on the life of a 50-year-old owner.

• Control of the company could shift among surviving owners, depending on the size of ownership interests transferred and the order of deaths.

Stock redemption agreements

A stock redemption agreement is another common form of a buy-sell agreement for small and closely held companies, particularly for companies with more than a few owners. Under a stock redemption agreement, the company takes out and is the beneficiary of insurance policies on the lives of each of the owners. When an owner dies, the stock redemption agreement requires the company to use the insurance proceeds to purchase the deceased owner’s share of the business from the deceased owner’s heirs or other designated beneficiaries. These policies are paid for by the company. Each life insurance policy should have a face amount equal to the agreed upon value of each insured owner’s ownership interest in the company.

Some of the advantages of stock redemption agreements are as follows:

• Stock redemption agreements are easier to administer for businesses with more than just a few owners, and fewer policies are required.

• The cost of the premiums on the lives of the owners is split evenly among owners, regardless of their age or condition of health.

• The company may have greater resources to make the required premium payments than would the individual owners under a crosspurchase agreement, including the ability to borrow funds to make payments, if necessary.

Some of the disadvantages of stock redemption agreements are as follows:

• The transaction occurs inside the company, and the life insurance policies and their proceeds are not protected from the claims of the company’s creditors.

• Owners with a higher percentage ownership interest in the company end up paying more of the cost of the premium payments.

• The redemption of a deceased owner’s interest by the company will not have the same favorable effect of increasing the tax basis of the surviving owners as would the case with a cross-purchase agreement.

• Under a recent U.S. Supreme Court decision (Connelly v. United States, U.S., No. 23-146, June 6, 2024), the life insurance proceeds may be added to the value of the company for purposes of valuing the deceased owner’s interest in the company for estate tax purposes, resulting in an amount significantly higher than the value of the agreed upon buy-out.

Which type of buy-sell agreement works better for you and your company will depend on a variety of factors, including the number of owners, their relative health and ages, the financial condition of the owners, the financial condition of your company and tax considerations. However, regardless of whether you choose a cross-purchase agreement or a stock redemption agreement, both varieties offer a sound solution to the problem of providing liquidity for the purchase of a deceased owner’s share, certainty of price and terms of the buy-out, continuity of operations and continuity of management for your business.

Please contact Christian Manalli with any questions at (312) 648-2300 or e-mail at [email protected].