A buy-sell agreement allows a business owner or partner who has died, become disabled, or retired, to sell their stake of the company. It can also give an exit strategy for business partners who no longer want to be a part of the company.
If your business does not have a buy-sell agreement in place, you may find yourself sharing the reins with a former partner’s spouse, children, or another party who has little understanding about your business and is not as involved in its success as you are.
How a Buy-Sell Agreement Works
A buy-sell agreement establishes a clear transition for ownership of the business when each partner dies or chooses to leave the business. This kind of legal agreement is commonly used in sole proprietorships, closed corporations, and partnerships.
A buy-sell agreement outlines the terms and conditions that business partners must follow if they leave the company. By planning ahead of time, you will protect your business, protect each partner’s interest, reduce headaches, and reduce financial risks.
What You Need to Know Before You Set Up a Buy-Sell Agreement
- The structure of the settlement or offer
- The actual monetary value of the business
- The source of funding
- Available life insurance options
Benefits of a Buy-Sell Agreement
There are several benefits of a buy-sell agreement for your business and partners, and these may differ depending on your business and needs. A few of the benefits of a buy-sell agreement include:
- It enables you and your family to confidently plan for the future.
- It creates stability for the business.
- It provides for estate tax planning.
- Those who rely on your company (employees, customers, suppliers, creditors, etc.) will feel more secure and are more likely to continue working with the company if they know there is a succession plan in place.
- Banks, lenders, and other financial institutions may be more willing to extend credit if they believe the business’s future is secure.
- Knowing the amount of money you will receive at retirement (as well as when, and from whom) allows you to start planning for retirement, rather than relying on the business for ongoing support.
Common Steps to Set Up a Buy-Sell Agreement
The following list includes the steps commonly used in setting up this kind of agreement. You can start by tapping into the expertise of your attorney, insurance broker, accountant, and other professionals to help get started.
- Establish ground rules. Each business is different, so it will be important to have common goals and valuation before you begin.
- Agree on a company valuation. It is good business practice to have a third party do this so there is no disagreement among the partners.
- Life Insurance can be used as the funding mechanism. When business partners sign buy-sell agreements, they usually take out life insurance policies as part, or all, of the funding vehicle. This ensures that the remaining parties have access to the funds required to buy out the deceased or disabled co-owner. You want to be completely certain that you have enough money to buy out your former partner.
Benefits of a Life Insurance Buy-Sell Agreement
- At death, life insurance generates a lump sum of cash to fund the buy-sell agreement.
- Life insurance proceeds are typically paid shortly after your death, allowing the buy-sell transaction to be completed quickly.
- If enough cash values have accumulated within the policies, the funds can be accessed to purchase your business interest after your retirement or disability.
- Life insurance benefits or proceeds are generally not subject to income tax, depending on the state and type of agreement; however, a C corporation may be subject to the alternative minimum tax (AMT).
Things to Remember
- Premiums can be expensive — especially for older partners.
- You will need to analyze, review, and update your plan every year.
- Some partners might be un-insurable.
- Your buy-sell agreement should be fully funded.
- Periodically, check the financial rating of your life insurance company. You want a financially strong insurer behind your buy-sell agreement.
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