The Right Buy-Sell Agreement Matters

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Published by Scott Roberts, Director of Estate Planning

 

Planning for the succession of your business when your partner is not a family member can be fraught with financial and relationship peril.  That clichéd, dramatic and rhetorical question “how would you like suddenly to be in business with your business partner’s spouse?” is apt because it is a common result for those who don’t plan.  But, as you will see, there is planning and then there is planning.  In this case, the former is merely having a buy-sell agreement and the latter is consciously choosing the optimal type of agreement.

Most business owners with a partner know they should have a buy-sell agreement which allows a surviving partner to purchase the deceased partner’s business interest at a contracted price, either mutually agreed from time to time or based on a formula related to the business’ financial information.  Such an agreement ensures a ready market for the deceased shareholder’s stock, while simultaneously allowing the surviving shareholder to retain control of the company, rather than suddenly be in business with any heirs who would have inherited the stock.  While the concept of a buy-sell agreement is simple, the type of agreement implemented can have a profound effect on the tax situation of the surviving shareholder.

 

A redemption agreement provides for the business entity to purchase the deceased shareholder’s shares, and is often funded by life insurance owned by the company.  This is the simplest structure and may be the best when multiple partners are involved.  However, the surviving shareholder will receive only a partial step-up in basis, at best, from the purchase and may, as a result, pay more in capital gains tax in the future if the business is sold.

 

A cross-purchase agreement provides for the surviving shareholder to personally purchase the shares of the deceased shareholder, and is often funded by life insurance owned by the shareholder (i.e. they each own a policy on the other).  While slightly more complicated to implement and fund, the surviving shareholder will receive a full step-up in basis from the purchase and can save capital gains taxes if the business is sold in the future.

 

To illustrate the difference between the two structures, consider a $10 million company owned 50/50 by two partners, each with a $1 million basis.  If the surviving shareholder under a redemption agreement later sold the business (assuming no appreciation and disregarding the Net Investment Income Tax), there would be approximately $1,800,000 of capital gains taxes due ($10,000,000 – $1,000,000 = $9,000,000 * 20% = $1,800,000).  However, that same surviving shareholder, had a cross-purchase agreement been implemented, would only have approximately $800,000 due in capital gains taxes ($10,000,000 – $6,000,000 = $4,000,000 * 20% = $800,000), a $1 million savings!

 

Several variables, including basis, purchase price and a future sale, have to line up for tax savings to be realized through a cross-purchase agreement.  But those savings can be so significant that taking the time to explore the best type of buy-sell agreement can be a $1 million exercise.

 

This information is not intended as authoritative guidance or tax or legal advice. You should consult with your attorney or tax advisor for guidance on your specific situation.  LPL Financial does not provide legal advice or services.

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