Tax and Financial Articles

The Need For Buy-Sell Agreements in Small Business

THE NEED FOR A BUY-SELL AGREEMENT IN SMALL BUSINESSES
By Glenn G. Schanel, CPA

All your working life you have strived to develop a successful business. The investment you make in your business is much more than just money or capital. It includes a substan tial amount of your time and hard work.

Over the years, the small business you started will grow based on your hard work. As a reward of this growth, a business’s income will increase and be available to you. In addition, the value of the business will also increase over time.

However, following your death, the business will have to be valued and that value will be added to your estate to compute the estate taxes due. The real question at this point is how to convert this illiquid business interest into cash to pay the estate taxes and other estate administration costs.

The general solution appears to be to simply sell the business or liquidate. Liquidation is not an attractive alternative because it is unlikely the liquidation value is equivalent to the business’s full fair market value. The better alternative is for the estate is to sell the business. But who will buy a closely held business interest? What is a fair price? When will the sale be made? Where will the funds come from?

This “dispositio n dilemma” is easily resolved when a buy-sell agreement is established. This agreement provides that:

• someone (e.g., the business entity, the surviving owners, or a key employee) will purchase a deceased owner’s interest, minimizing the possibility that the business might fall into the hands of outsiders
• at an agreed -upon price, minimizing the possibil ity that the parties involved will not be able to agree on a proper value for the business, and
• the deceased owner’s estate is obligated to sell the interest at that price, minimizing the chances that the parties may not live up to their agreement.

A properly drafted buy-sell agreement also minimizes the possibility that funds will be unavailable to make the purchase, and provides a deceased owner’s estate with needed liquidity by converting an illiquid asset into cash. It’s easy to see why a buy-sell agreement is so valuable. It helps assure business continuity for the surviving owners and fair treatment of the deceased owner’s heir(s).

The advantages of implementing a Buy-Sell plan are somewhat obvious: continuity of management; to create a ready market for the business interest; to provide a fair and reasonable price; and to peg the value of the business interest for federal estate tax purposes.
There are several types of Buy-Sell Agreements. Which one to use depends on several factors,including the number of business owners, the relative ages and health status of the owners,concern about the Alternative Minimum Tax, and whether a step-up in cost basis is desired by the surviving owners. Some of the most common types of Buy-Sell Agreements are the Entity or
Stock Redemption, Cross Purchase, Wait-and-See, Mixmaster, and the One Way Buyout.

Once the type of plan is chosen, it is very important to decide how the liability for the purchase price will be funded. Several possibilities exist:

• Surplus, which consists of an existing fund of the purchaser
• Sinking Fund, also known as a savings account or savings plan
• Borrowing, obtaining financing from a third party, such as a bank
• Installment Sale, financing from the seller
• Life Insurance, which may provide a death benefit and a sinking fund

Each of these funding options has advantages and disadvantages. However, the disadvantages generally outweigh the advantages in all of them except for the use of life insurance, which by its nature provides the cash, in the amount needed, at exactly the time it’s needed, usually without taxation. For this reason, life insurance is most often the preferred funding vehicle in buy-sell planning. The annual premium provides an ascertainable cost and the policy provides a benefit no other plan accomplishes — guaranteed funds in the event of a premature death. The policy, if a whole life policy, may also act as a savings or sinking fun since the cash value in the policy is accumulated on a tax deferred basis. And the death benefit is income tax free!

In sum, life insurance meets the client’s objectives. First, it not only has an ascertainable cost, but it also is the least expensive. Second, the availability of the funds is certain in the case of a premature death. It may also act as a sinking fund.

Lastly, the use of the insurance allows the surviving owner to continue the business free and clear. It also allows the deceased owner’s family to receive the cash for the decedent’s interest, since they are paid in full and there is no installment sale, borrowing, or a shortfall of funds.

Glenn G Schanel, CPA and Associates, PA

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Glenn G. Schanel of Glenn G Schanel, CPA and Associates, PA represents American General Life Insurance Company (AGL), with securities offered through American General Securitie s Incorporated (AGSI), 2727 Allen Parkway, Houston, Texas, 77019. Member NASD and SIPC. AGL and AGSI are member companies of American International Group, Inc. (AIG). Glenn G Schanel, CPA and Associates, PA is a separate entity from any member of AIG. Mr. Schanel can be reached by calling (561) 624-2118.

The U.S. Chamber of Commerce has endorsed for its members the products and services of member companies of American International Group, Inc. (AIG), the leading U.S.-based international insurance and financial services organization. American General Life Insurance Company, a member company of AIG, provides a broad portfolio of top-tier financial products for businesses, families and individuals.

The comments in this article are those of the presenter and not necessarily those of AIG American General. Neither AIG American General nor its agents provide legal or tax advice. You should always consult with your tax and legal advisors about the appropriateness of this concept to your business, and ask your life insurance representative for the best product with which to fund this plan.

AIG American General is the marketing name for the life insurance companies and affiliates of American International Group, Inc. (AIG), that comprise AIG’s Domestic Life Operations, including American General Life Insurance Company.