Without proper planning, the premature death of a business owner may result in the business being liquidated, sold to outside parties, or surviving family members may have to become active in the business. To plan for the orderly disposition of the business, a buy-sell agreement should be considered.
A buy-sell agreement can be between shareholders of a corporation, partners of a partnership, or a key employee and a sole proprietor. The agreement obligates the surviving business owners, key employee, or the business itself to purchase the interest of the deceased owner. An attorney will need to prepare the buy-sell agreement.
Advantages of a properly drafted buy-sell agreement
- Creates a guaranteed market for the business interest.
- Allows those who are interested in continuing the business to do so without interference from the deceased owner's heirs.
- Provides liquidity for the estate of the deceased owner by turning the business interest into cash.
- Establishes the value of the business for federal estate tax purposes.
Types of agreements
A buy-sell agreement may be structured in one of three ways. You should seek the advice of your tax advisors to determine which is best for you.
- Cross purchase — This type of agreement involves the business owners (shareholders or partners) entering into an agreement among themselves whereby the surviving owners are obligated to buy the interest of the deceased owner, and the estate of the deceased owner is obligated to sell.
- Entity — This type of agreement binds the business itself to buy the interest of the deceased owner, and the estate of the deceased owner is obligated to sell. If the business is the corporation, this entity agreement is sometimes referred to as a stock redemption agreement.
- Wait and see — If it seems difficult to decide whether to use cross purchase or entity, a "Wait and See" may be utilized. This type of agreement allows flexibility in that it is not decided until the owner's death whether the surviving owners or the business purchases the interest of the deceased owner.
Where does the money come from to purchase the business interest?
Personal funds of owners — Most business people do not keep large sums of liquid assets that would be needed to purchase the deceased owner's interest. Most money would be in their businesses.
Sinking fund — The premature death of an owner may not give the business time needed to accumulate the purchase price.
Borrowed fund — A bank may not be willing to lend money to a business that has recently lost an owner or the cost of the interest of the loan may be excessive.
Installment payments — The heirs of the deceased owner may not get the sum or money needed to settle death costs and there is no guarantee future payments will be received if the business fails.
Life insurance — There are many advantages life insurance offers that the other alternatives do not:
- Life insurance annual premiums are often a small fraction of the death benefit.
- Death benefits are available when needed, regardless of when the owner dies.
- Death benefits are generally federal income tax-free.
A State Farm® agent can help you choose an insurance program that will meet your objectives.
State Farm Life Insurance Company (Not licensed in MA, NY or WI)
State Farm Life and Accident Assurance Company (Licensed in NY and WI)
IL - 37.2