In our previous posts, we covered why you may want to have a buy-sell agreement and what is included and addressed in a buy-sell agreement.
This post will help you understand the key differences between the two main types of buy-sell agreements, cross purchase and entity purchase plans. A defining question to be answered by the agreement is whether an exiting owner sells their ownership to their partners or to the business itself. But as you will see, there are a number of other considerations with administration, tax, and financial implications.
We’ll start with the most common form among businesses, the entity purchase or stock redemption buy-sell agreement.
Entity Purchase Buy-Sell Agreement
The entity purchase, or stock redemption, buy-sell agreement is typically the easiest solution to implement and understand. It’s estimated that 80 to 85 percent of arrangements are entity purchase. This form is most common for situations involving 3 or more owners, as you’ll soon learn.
In this form, the business is obligated to purchase the business interest from a departing or deceased owner or shareholder. The business can then retire these shares. The remaining owners experience reverse dilution, so that their ownership percentage increases such that the remaining owners comprise 100% of the outstanding ownership or stockholders.
In terms of funding strategies, the business will own and be the named beneficiary on insurance policies for the owners. If an owner dies or becomes disabled, the business will make a claim on the corresponding policy and use the proceeds to buy the outstanding shares from the owner or their estate if deceased.
Advantages of an Entity Purchase Plan
The entity purchase or stock redemption plan is easier to implement and understand compared to the cross purchase arrangement. As the business owns the insurance policies and is the sole party to engage with the owner or their estate, there are fewer complications.
The estate of the deceased owner receives a tax advantage with an entity purchase plan. If the owner has died, their estate will receive a step up in basis in the value of their business interest at death. Thus when the estate sells the interest to the business for the new basis amount, it does not face any capital gains or income taxes.
Disadvantages of an Entity Purchase Plan
While simpler to understand, the remaining owners do not receive a tax advantage like the departing or deceased owner.
In the event of an exit, the remaining owners now own a greater percentage of the business due to reverse dilution, with no increase in their basis. When they in turn eventually exit and sell their interest, they will pay greater capital gains taxes due to the larger taxable gain than with a cross purchase and it’s associated increase in basis for the remaining owners.
This consequence is an issue if the owner sells in their lifetime. Because of the aforementioned step-up in basis at death, their estate would again have a basis equal to the value of it’s business interest.
Cross Purchase Buy-Sell Agreement
The cross-purchase buy-sell agreement typically occurs with a 2 owner situation. While the business purchases an exiting owners interest in a an entity purchase plan, the remaining owners purchase the business interest of their departing or deceased partner with a the cross purchase plan.
Advantages of a Cross Purchase Plan
The surviving owners have a better tax consequence from the cross purchase plan than the entity purchase plan in their own future exit.
When the owner(s) purchase the business interest of their departed or deceased owner, their basis increases by what they pay to the exiting owner or estate of the deceased owner. This then improves the tax consequences of their exit if it occurs during their lifetime.
Consider a business owner selling to their partners at retirement for $1,000,000. 5 years ago, one of their business partners died and they or the business purchased their business interest depending on their type of buy-sell agreement. And we’ll assume a flat 20% capital gains tax for simplicity. To keep things simple, we’re assuming no depreciation, no state taxes, nothing else.
Let’s see what they pay in two scenarios:
Tax Consequences of a Entity Purchase Agreement
The owner’s original basis is $50,000 and they had no increase in basis 5 years ago when the corporation redeemed the shares of the deceased owner, for a total basis at exit of $50,000 against the $1,000,000 sale. They pay the 20% capital gains tax on the $950,000 sale, for $190,000 in total.
Tax Consequences of a Cross-Purchase Agreement
The owner’s original basis is $50,000, and 5 years ago they paid $500,000 to the estate of the deceased owner, for a total basis of $550,000 against their $1,000,000 sale. In this case, the owner pays 20% on the $450,000 gain, $90,000 in total. This is a decrease of $100,000 in taxes levied against the selling owner, and that difference grows as the business increases in value.
For figures regarding your specific situation, please refer to your accountant and financial team.
Disadvantages of a Cross Purchase Plan
The main disadvantages of the cross purchase plan are the complications that arise given each owner must purchase and administer a policy on each of their partners.
With more than 2 owners, there are many more policies to administer and manage. The math is for N owners, the agreement requires (n) x (n-1) policies.
With 3 owners, there are 6 policies.
With 4 owners, there are 12 policies.
And because each business owner manages policies directly and must pay premiums personally, there is a much bigger risk for compliance and fairness in this situation.
Trust becomes an issue among owners, as people don’t generally like the idea of their business partners directly owning life insurance on their life. Owners usually prefer the business to be the owner on a policy to feel more comfortable that a policy stays in force.
Premium Differences due to Health and Age
Some business owners can face large differences in insurance premiums due to differences in health and age. Consider two business owners with an age gap of more than 10 years or if one has a serious medical condition.
Owner A pays $1,500 a year for a policy on Owner B’s life, while Owner B pays $10,000 a year for a policy on Owner B, who has a health condition that makes obtaining a policy more difficult and increases the cost of their life and disability insurance.
In some cases with large age differences or a much older owner, some insurance companies won’t even make an offer for coverage. In such cases, it’s important for owners to build reserves for triggering events that can’t be otherwise insured for.
As you can see, the structure of a buy-sell agreement is very detailed and nuanced. It’s unique to each business and the involved owners, and many factors have to be addressed and considered before an agreement can be agreed upon and funded.
It is absolutely necessary that business owners engage with legal counsel and financial professionals to discuss their unique situation.
Our final post in this four-part buy-sell agreement series will look at this last point, how a buy-sell agreement is funded for each triggering event.
* The above information is intended to be educational only, and not advice to any particular situation. You should always consult with your legal professional when it comes to your own situation.