A buy-sell agreement is a legally-binding agreement that prepares for the future sale of a business or the purchase of a co-owners interest in the event a number of different situations including, if one co-owner dies, is forced to leave the business, or chooses to leave.

The 3 types of buy-sell agreements are:

1. Entity Buy-Sell

The business enters into a written agreement with the owners to purchase the interest of each owner in the event of disability, death, divorce or departure of a co-owner.

2. Cross-Purchase Buy-Sell Agreement

Individual owners agree to purchase the interest of other owners. Each individual is the owner and beneficiary of a life insurance policy on each of the other owners, and the policy proceeds are used to pay the purchase price.

3. Partnership Administration Succession Strategy (PASS)

Individual owners for a separate partnership and the partnership acquire life insurance policies on all the owner and administers the provisions of the buy-sell agreement. This approach has numerous tax and financial advantages compared to traditional stock redemption or cross-purchase agreements particularly in the case of C or S corporations with more than two owners.

Buy-Sell Agreements Comparison

Cross-Purchase Buy-Sell Redemption Buy-Sell
Parties to the plan The plan is between the owners. The plan is between the business and its owners.
Income tax treatment by surviving business owners Purchasing business owners get a new basis in acquired ownership interest. Survivors own a larger percentage of the business, but the basis in the interest does not change.
State law restricting redemptions N/A State law may require redemptions to be made from surplus only.
Family attribution rules. (IRC Section 318) N/A These rules may cause what appears to be a total redemption of a decedent’s stock to be treated as a taxable dividend.
Availability of life insurance policies to business creditors Not usually. If creditors are able to “pierce the corporate veil,” policies may be available to them. Cash values and proceeds are generally available to the creditors of a business.
Premium payer Business owners. If the business pays, it must be treated as additional compensation. The business. It is the owner, beneficiary, and premium payer.
Transfer for value issues A purchase of policies by a surviving owner creates a transfer for value. This will cause proceeds to be partially subject to income taxation unless the surviving owner is the insured. Since policies are owned by the business there is no need to make a transfer when an owner dies.
Complexity At death, there may be multiple buyers of the decedent’s business interest. In an insured plan, this also means multiple policies on each owner. At death, there is only one buyer (the business) and one seller (the deceased owner’s estate).
Number of policies required May require many policies. The formula is: Number of owners multiplied by numbers of owners – 1. For example, if there are 5 owners, you need 20 life insurance policies: 5 x (5-1). Requires only one policy for each owner.
Other considerations 1.   If an owner is having trouble paying premium, the policy may lapse.

2.   The cost of the plan may be higher if the business is in a lower tax bracket than the individual.

3.  Voting power may be altered in an undesirable way.

1.   It permits pooling of premium obligations

2.  “Unreasonable compensation” questions do not arise. This issue arises when salaries are increased to pay premiums for life insurance used to fund cross-purchase agreement.

3.  Life Insurance proceeds are included in adjusted current earnings for purposes of corporate alternative minimum tax.

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