Professional Services Accounting ARTICLE -
A Winning Formula - Buy-sell agreements and life insurance bring peace of mind

Target Audience: Law Firm Professionals, Lawyers, Professional Service Organizations, Practice Groups, Industry Experts, Soon to be Retirees

As a business owner, your tendency may be to focus on today’s headaches. But you still need to think about tomorrow’s. For instance, what would happen to your company if you weren’t around to run it?

Retirement may be years away. But disability and premature death can set into motion adverse events for your company and family — unless you’ve considered your options much earlier.

That’s why a sound buy-sell agreement, typically funded by life insurance, is a winning formula for preserving your business and your family’s financial future.

What’s the point?

The main purpose of a buy-sell agreement is to keep your business running after your (or another owner’s) departure. It enables the execution of a smooth transition in the control and ownership of the entity, allowing your company to remain in good standing with clients, creditors and employees — therefore preserving the value of the business.

A buy-sell agreement also establishes a ready market for your shares. This ensures that, when you eventually do (or must) sell, there will be a fair price, clearly defined terms and available funding.

Of course, creating a buy-sell agreement forces you to ask some tough questions, including:

• What events should trigger a sale?
• Who should purchase the shares — the company, other shareholders or both?
• How much will be paid?
• How will purchases be funded?

Death, retirement, withdrawal from employment, disability, divorce or a contemplated sale to a third party are all valid triggering events to initiate the buy-sell process.

Once a triggering event occurs, you also must decide whether the sale should be:

• Mandatory,
• Optional to the shareholder, or
• Optional to the company.
• Death is usually one of the key triggers. It’s generally mandatory that someone buy the deceased’s shares to generate liquidity for the deceased’s family.
• Similarly, if a shareholder-employee is no longer able to work, a buyout would generate funds to support him or her.

Why life insurance?

As mentioned, funding a buy-sell agreement with life insurance is often the best way to go. There are a number of reasons why, including:

It’s basically a sure thing. Life insurance is the only funding option that virtually guarantees the immediate availability of the full buyout amount at your death, assuming sufficient coverage and a history of timely premium payments.

You’ll secure a tax break. Under current tax law, death benefits aren’t subject to income tax. Thus, the full proceeds will be available for the buyout. An added perk: If a premature death occurs, the total premiums paid on a life insurance policy are normally a fraction of the cash received as a death benefit.

If yours is a policy that accumulates cash value, this amount is also figured on a tax-advantaged basis. The cash value may help fund a retirement or other buyout during your lifetime. Keep in mind, though, that your health and age play a large part in obtaining life insurance.

Your shares’ value will be established. A buy-sell agreement to cover the value of each owner’s shares eliminates the need to negotiate a value every year. The agreement provides an independent mechanism for determining a price or pricing formula for the business interest, lessening the potential for disputes.

The agreement and any insurance policies should, however, be reviewed periodically as the business grows and as it undergoes changes in structure or ownership.

You can keep out unwanted shareholders. Establishing a buy-sell agreement and funding it with life insurance prevents unwanted parties from acquiring an ownership interest. Proper planning will help preclude family members or third-party competitors from acquiring or claiming a stake in your company’s daily decision making.

If life insurance isn’t used to fund the buyout, the buy-sell agreement needs to state how and when the payment will be made to avoid possible misunderstandings or legal actions. And, of course, life insurance isn’t as helpful in funding purchases of your shares during your life.

Other options for funding a buy-sell agreement include paying out the purchase over a period of years, borrowing the necessary funds or using specific business assets, such as a parcel of real estate.

Are there any other reasons?

If you’re still reluctant to create a buy-sell agreement because it’s unpleasant to contemplate death, disability or other events that might dictate an ownership change, at least think about your loved ones. The agreement, after all, helps set the value of the interest for federal estate tax purposes. And this “arm’s-length” negotiated value helps reduce the possibility of an IRS challenge.

In the meantime, the agreement expedites your estate’s disposition. Because you’ve negotiated the sale terms during your lifetime, family members are generally assured a timely cash disbursement. And it can alleviate any disputes between your heirs and the surviving business owners.

Furthermore, a buy-sell agreement relieves loved ones from having to make business decisions. A relative who never worked for your company probably won’t want to assume the ongoing worries of future operations. Your agreement’s terms can stipulate that disinterested heirs must be bought out and protected from such responsibility.

Finally, the agreement avoids negotiating price and terms when the estate may be in a weak bargaining position. The lack of a buy-sell agreement before an owner’s death alters the playing field. In worst cases, when an estate is facing administrative and tax costs and has few liquid assets, a “fire sale” may occur — something you’d probably never wish on your family.

Will this hurt?

The process of drafting a buy-sell agreement isn’t painless. It involves time and energy, and it may force you to ponder circumstances you’d rather not think about.

But as long as you procure the help of your CPA, attorney and perhaps other trusted advisors, you’ll get through it just fine — thousands of other business owners already have.

Find out how our expertise in professional services accounting can add value to your business. Email us or call us at 1 (888) 875-9770.

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