Courtesy Bond Schoeneck & King
By Frank C. Mayer
It’s been said that all good things must come to an end. This includes an ownership interest in a closely-held business.
Many successful business owners concentrate so much of their creative energy and talent on growing their business that they may not set aside the time for, or may choose to put off, making critical decisions about how they plan to deal with the eventualities of life.
Among the important questions that the owners of a closely-held business should address are: How long do I want to be in business? What happens if I become ill or pass away? Will I be able to preserve the value of my business for my loved ones? If something happens to one of my business partners, how do I prevent an unwanted third party from acquiring an ownership interest in the business?
These threshold questions are easily addressed in what is commonly referred to as a buy-sell agreement, which is a binding agreement between the owners of a closely-held business. By entering into a buy-sell agreement, the owners of a closely-held business can take some comfort in knowing that a well-considered plan is in place to smoothly guide both the owner and the business through the transition process.
A buy-sell agreement may be used by various forms of businesses, including corporations, limited liability companies, and partnerships. Buy-sell agreements are typically structured as a cross-purchase transaction, as a redemption transaction, or as a combination of a cross-purchase and a redemption.
Regardless of the transaction form, a number of operational and tax issues must be addressed, both at the time the buy-sell agreement is executed, and at the time the buy-sell triggering event occurs. Funding of the buy-sell agreement may be accomplished with, among other things, life insurance, disability insurance, financing by the business or the remaining owners, with the general assets of the business or the remaining owners, or any combination thereof.
In a cross-purchase transaction, when one owner dies, becomes disabled, or leaves the business, the other owners purchase the departing owner’s interest. Typically, the owners purchase life insurance, and sometimes disability insurance, on each of the other owners and, as beneficiaries, use those insurance proceeds to purchase the interest of the deceased or departing owner.
The advantage of a cross-purchase transaction is that the purchase of the departing owner’s interest is made at fair market value, which provides a “step-up” in the purchaser’s tax basis for the interest purchased. This may reduce any tax the purchaser pays at the time the purchaser disposes of his or her interest in the business at some later date. A cross-purchase also allows the remaining owners to alter their ownership percentages by allowing certain owners to purchase a greater percentage of the interest to be acquired.
The disadvantage of a cross-purchase transaction is that it can be complex to administer because each owner has to purchase insurance policies on each of the other owners. For example, in order for four owners to purchase life insurance on each of the other owners, it would require 12 policies (4×3).
The required number of policies would double if disability insurance is also purchased. Another concern with using the cross-purchase structure is that the owners bear the disparity in policy cost for factors such as age and risk, which often means that younger owners may have to absorb higher premiums to cover the cost of insuring older and/or less healthy owners.
In a redemption transaction, the business buys the deceased or departing owner’s interest. The main advantage of this structure is that it is often easier to administer because, typically, the business owns a single life and/or disability policy on each owner and, therefore, the business bears any disparity in policy cost on the insureds. From a financial perspective, it is the business that funds the redemption of the departing owner’s interest. The business may also be able to take a tax deduction on any interest that it pays to finance the redemption.
While a redemption may be easier to administer than a cross-purchase when multiple owners are involved, the redemption approach has a number of disadvantages. Unlike a cross-purchase, the remaining owners in a redemption transaction can’t change their ownership percentages by having selected owners purchase different percentages of the departing owner’s interest.
In addition, the proceeds of insurance received by the business may be included in the deceased owner’s estate if that individual was a majority owner of the business. Finally, unlike a cross-purchase transaction, the business gets no “step-up” in the cost basis for the interest it purchases, meaning that the remaining owners may pay a greater tax when they eventually separate from the business.
In comparing the two structures, a cross-purchase transaction may be favored in cases where there are few owners, each of which are of similar age and risk level and have relatively large estates. A redemption transaction may be the best choice if the business has many owners and/or there is a disparity in the age and risk factors between the owners, and/or each of the owners have relatively small estates.
Once the owners decide on the proper structure of the buy-sell agreement, they must agree on the appropriate method to value the departing owner’s interest in the business. Some of the most common methods of valuation include: a discounted cash flow analysis, which is typically based on a projection of future cash flows of the business; a sales and/or earnings analysis based on historic financial information; or a valuation based on the sale of comparable businesses.
Whichever valuation method is selected, it should be reviewed and updated every few years to ensure that the method utilized remains the best approach to protect the interest of both the deceased or departing owner and the remaining owners. In addition, the level of insurance coverage in place should also be reviewed regularly to ensure that it remains in step with the value of the business.
Finally, the owners of a closely-held business may decide that the buy-sell agreement should provide discounts to the appraised value for certain factors such as a lack of majority interest or a lack of marketability.
It is critical that owners of a closely-held business work closely with their advisors to structure, enter into and maintain a buy-sell agreement that carefully considers the advantages and disadvantages of a cross-purchase and a redemption approach, as well as determining the correct method to fund and value the interest to be purchased.
Mayer is a member of Bond Schoeneck & King representing individuals and closely-held businesses in a variety of commercial and tax-related matters.