If you own a business, you need a clear template to follow your buy-sell agreement that details the triggering events, how you will fund it, the agreed value of the business, and the structure of the arrangement. But what is even more important is that you need to make sure that you fund the agreement with life insurance that is not paid from the corporate checkbook. You can roll the dice, ignore the issue altogether, and just go into business with your partner’s wife when they die, but I’ve seen it happen on several occasions – Not pretty
Most who experience this prediction will compare it to water-boarding, it won’t kill you, but it will definitely make your life miserable.
Many business owners who have not funded their buy-and-sell agreements fail to do so because they fear the expense of life insurance policies that are necessary to carry out the agreement properly. But this should not be a reason for the delay in purchasing, in fact, the cost of a funded buy-sell (life insurance premium) provides this advantage compared to peanuts.
And a business without a family business or closely held can result in severe financial and tax pain upon the death of an owner. Life insurance premiums are much less expensive than the potential financial pain.
What is the benefit of a cross-purchase by-sale agreement?
Please understand that the legal document detailing the cross-purchase purchase-sale agreement is very specific and detailed. Like, here we are trying to give an accessible explanation at a high level and not explaining many legal aspects. The only buy-sell discussion here is the cross-purchase agreement.
This is the most basic type of agreement and it is a good place to build your basic knowledge on the subject. It is also the most used buy-sell agreement that we have seen in 20+ years.
Overview of a basic cross-purchase plan
In a basic cross-purchase agreement, when the owner of a business dies, the surviving owners agree to purchase the deceased owner (s) of the business. Each owner agrees to purchase the other’s interest in the event that one of the owners dies.
So, in this scenario, each owner owns insurance policies over the life of an applicant, a premium payer, a beneficiary, and the owners of each other business.
Below is a graphic with an example that will help you sort it all out.
When an owner dies, each surviving owner / beneficiary will receive an insurance policy death benefit. Then each surviving owner makes a cash payment to the deceased owner’s property or family (depending on how the agreement is reached) and in return the property transfers the shares of the deceased owner of the company.
What results is that unique shares of the company’s family are magically transformed into cash and the owners who still own all the business. Everyone wins, the deceased owner’s family gets cash and the remaining owners of the business are not forced to stay in business with the deceased owner’s family.
What is the structure of the agreement?
Let’s use Bob and Sam as our examples. He is the owner of XYZ Magic Button Company.
- Bob and Sam make a cross-purchase agreement.
- Bob and sam Apply for life insurance policy On each other. Each of them is the owner, beneficiary and premium payer of a policy over the life of each other.
- Assuming Bob dies, the life insurance company pays Sam the death benefit.
- Bob’s shares of XYZ are held by his estate / family.
- Bob’s estates / family sell their shares to Sam under a pre-arranged cross-purchase agreement.
- Sam uses life insurance proceeds to pay Bob’s family cash for Bob’s shares in XYZ.
- Now Sam XYZ is 100% owner of Magic Button Company.
Here is a picture to see how it happens.
Establishing a Value for Business
This is one of the most important aspects of the agreement, Sam and Bob must set a price for their company. For them to ensure that the arrangement is properly funded, both require adequate life insurance coverage on each other at the “date of death” value of the deceased owner’s shares. There are several ways to approach professional assessment:
- An appraised value – which is determined by an independent valuation when the business interest is actually sold
- Capitalized Earnings Approach – Price is determined by an income-based model. It derives the value of the business by dividing the discretionary earnings of the selling party by the capitalization rate.
- Specific Fixed Price – Owners regularly fix prices based on agreement
- Formula Value-defined formula includes several factors that the owner agrees to in cross-purchase
- Book value – the actual book value of the shares of the owners on the date of death
What is it Benefits of a cross-purchase plan?
Well, apart from the obvious benefits that I have already discussed, there are others that are much more concrete in nature. If Bob dies and Sam buys all of Bob’s shares according to their purchased contract, then Sam receives an increase in the cost base of the acquired shares that equals the full purchase price.
This is a great thing for Sam. If later down the road, he decides to sell all of the XYZ Magic Button Company, the cost price of at least half of his shares will be too high, reducing capital gains.
In addition, there are at least two other advantages that are related, the business is not involved in a buy-sell agreement at any official capacity, which means
- Businesses are not forced to reflect the value of life insurance on their balance sheets. This will increase the value of the business.
- Because the business is not a party to any transaction, life insurance is not subject to the Alternative Minimum Tax (AMT) calculation.
Are there any disadvantages?
There are a few things out there that can complicate matters and not make the cross-purchase type of buy-sell agreement so spectacular.
- If there are too many owners, it can quickly become an obscene number of policies that have to be bought to make the agreement work. The formula for calculating the number of policies is n (n – 1), where n is equal to the number of owners. Example: If there were five owners, 20 policies would have to be bought… seriously? He leaves with a little hand.
- There may be a violation of the price rules for transfer to owners, if to later fund the purchase, the deceased’s property transfers all remaining policies to the surviving owners. But there is much more that I cannot do here because it is a subject unto itself.
Lastly, it is always best if you have a competent attorney and / or tax advisor who is involved in the process of deciding on the right type of buy-sell agreement for your business. But if you have a small business with two owners, a cross-purchase buy-sell agreement is probably your best bet.