Buy-Sell agreements are contracts between between business owners for the purchase and sale of a practice in the event of death, disability or retirement. This article will focus on the former two events.
A buy-sell agreement will establish a pricing formula for the practice, serve to have a ready buyer for the practice and may be used to value the business interest for federal estate tax purposes. All multi-professional practices should have a buy-sell agreement that addresses both death and disability. Both of these concerns are equally important and require attention.
The disability buy-sell takes a little more work to construct because of the variables associated with the following two questions:
Once these two variables have been determined, the disability and life buy-sell language should be similar.
It is important to value the practice properly in order for the price to serve as the decedent’s value for federal estate tax valuation. Generally, IRS revenue code 2703 requires that the following three items be used when developing the price for estate tax purposes:
Thus, when valuing the practice, it is recommended that a pricing formula be used and not a fixed dollar amount. Also, setting a price far below fair market value may require additional valuation for estate purposes.
A buy sell plan can be funded with insurance, bank loan or current profits. Most practices will choose to use insurance for the funding mechanism because of low cost and flexibility. For example, when considering funding the disability provision of a buy-sell agreement, a disability buy-sell policy will allow for lump sum funding. Without this policy, a bank loan would probably have to be obtained to buy out the disabled owner’s interest. The time it takes to apply for the loan plus the debt service may outweigh the premiums for the disability policy.
The next item to consider for the buy-sell agreement is whether it will be a cross- purchase or entity/ stock redemption. We will assume that the practice will be buying insurance to fund the agreement. In a cross-purchase arrangement, the individual owners will purchase policies on each other. The business owner being insured should not be the policyowner on their policy. Owner #1 should be both beneficiary and policyowner for owner #2. At the death or disability of an owner, the funds are available for the other owner to purchase the business interest. A cross-purchase works well when there are only two owners. If there are more than two owners, a cross-purchase should be done through a trust. This avoids having to buy multiple policies for each owner. (Additional tax issues relating to transferring policies after the first death may arise with a corporation, however, they is beyond the scope of this article.)
An entity or stock redemption buy-sell will have the practice apply for and be the beneficiary of the policies. The practice would receive the policy benefits and redeem the shares from the deceased/disabled owner. This works well when there are more than two owners, however, there are some disadvantages when compared to a cross purchase agreement. First, with large practices that are incorporated, the receipt of life insurance benefits may trigger an alternative minimum tax issue. Secondly, surviving partners will not receive a stepped-up basis for the decedents business interest. This may cause a larger capital gain to be recognized when the shares are subsequently sold to a new, incoming owner. (With additional fees and planning, owners of S-corps and partnerships may be able to receive the stepped-up with an entity arrangement.)
Please consult your accountant and attorney regarding the topics discussed in this article.
For more information regarding funding a buy-sell agreement and other financial services needs, contact Treloar and Heisel, LLC. at 800-345-6040 or visit www.treloaronline.com.
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