Posted on: February 1st, 2019
If you’re a co-owner of a business and were to die, what would happen to your equity in your business?
If you have a partner and he or she were to die, would you want to be in business with that person’s spouse—or children?
If you sell part of your company to a private equity firm and then die sometime afterward, how can you be sure your loved ones and heirs won’t be cheated if that private equity firm attempts to buy them out?
As a business owner, it’s time to ask yourself these tough questions—or revisit them if you haven’t thought about them in years. The fact is, without proper planning, the sudden death of a co-owner can have serious financial consequences. It can, for example:
The good news: There’s a solution—called a buy-sell agreement—that can help avoid all of these negative outcomes. By having this agreement in place, you can be more confident that the uncertainties concerning your business after your death or the death of a business partner will be addressed as you would want them to be.
A buy-sell agreement is a legal contract between co-owners of a business, or between the business and the co-owners. It sets out what will happen with a co-owner’s equity if he or she dies—guaranteeing a buyer and guaranteeing a price. Buy-sell agreements can also deal with situations in which a co-owner is forced to leave a business or chooses to exit.
A critical element of a buy-sell agreement is the approach used to value a business. The aim is to avoid any litigation over what the equity is truly worth. There are two basic approaches:
Buy-sell agreements must be funded in order to work, and there are several ways to fund them. For example:
There are two principal types of buy-sell agreements, and a third version that combines elements of the other two. Here’s how they work.
Each co-owner will buy the equity from the estate of another co-owner based on the agreed-upon terms. This approach can be very effective for businesses with relatively few co-owners. Usually, each co-owner will have life insurance policies on the other co-owners under this type of plan (see Exhibit 4).
These are the primary steps with a cross-purchase plan:
Advantage: If the business is later sold by the remaining partners, they will have increased their basis in the business by using a cross-purchase plan—saving them taxes when they sell.
Warning: Cross-purchase plans often are too unwieldy when there are many co-owners, because it can become difficult to determine who will buy what percentage of the equity of the deceased co-owner. It also often becomes complicated and inefficient to fund this arrangement. For example, it may be very expensive to have multiple life insurance policies on all the various co-owners. That said, there are some variations of cross-purchase plans that address these concerns—such as a trusteed cross-purchase plan incorporating a trust or use of certain partnerships. The addition of the trust regularly avoids the need for multiple life insurance policies, thereby reducing costs.
In this case, the business entity—not the co-owners—takes out the life insurance policies and pays the premiums. When a co-owner dies, the company can purchase his or her equity with the proceeds from the life insurance policy. This arrangement tends to work well when there are a large number of co-owners, as it is usually less complex than a cross-purchase arrangement (see Exhibit 5).
This type of plan unfolds along these steps:
With a hybrid plan, the business usually has the first option to purchase the equity of the deceased co-owner. If the business chooses not to buy the equity—due to tax-related considerations, for example—the co-owners have the option to do so. A hybrid plan is more complex than the other two approaches (see Exhibit 6), but it provides greater flexibility in structuring the purchase of the equity from the deceased co-owner’s estate.
These are the major steps with a hybrid plan:
Conceptually, buy-sell agreements are pretty straightforward. But clearly, there are important nuances and complex issues to consider when determining the best type of buy-sell as well as the right funding mechanism for your needs. Depending on various factors—such as the number of co-owners in a business—things can get complicated fast. With that in mind, consider working with a financial or legal professional you trust who is also well-versed in the area of buy-sell agreements.
This report was prepared by, and is reprinted with permission from, VFO Inner Circle. AES Nation, LLC is the creator and publisher of VFO Inner Circle reports.
Disclosure: The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra IS or Kestra AS. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by Kestra IS or Kestra AS for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS.
Fusion Wealth Management is not affiliated with Kestra IS or Kestra AS. https://www.kestrafinancial.com/disclosures
VFO Inner Circle Special Report
By Russ Alan Prince and John J. Bowen Jr.
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