Key-Man / Buy-Sell Agreement
A successful Business Succession Plan will use a Buy-Sell Agreement, which values the business, and defines a procedure for transferring the ownership interest. The plan may also provide a stream of income to departing owners, their spouses and families. The Buy-Sell Agreement places owners on equitable, predictable footing and provides a way to assure the business will continue.
During the development and execution of a Buy-Sell Agreement you can set for when and how your partner can take over your share of the business. This can be during you lifetime, if you or your business partner choose to retire or are no longer able to work, as well as after you have passed away. A Buy-Sell can provide the answers to important questions that will likely surface at these critical times.
For example, a B-S may provide a guideline or formula for valuing your business when it is time for you or your partners to buy or inherit each other’s business share. If you pass away your business share will be part of your taxable estate and you must determine its value. Having a prior valuation in place can be critical to determining the methodology for such valuation. Most importantly, it can provide a way for your spouse or other heirs to be paid out your interest in a business i.e. in a lump sum or over time through installment payments. The B-S can ensure that all owners and their families are treated fairly in the future, come what may.
Types of Buy-Sell Agreements
- Redemption Agreement: The business buys the share of a departing or deceased owner.
- Cross-Purchase Agreement: The remaining owners purchase the shares of a departing owner.
- Hybrid Agreement: Either the business or the remaining owners purchase a departing owner’s share.
Often a buy-out of a business share can be funded by key-man insurance, also known as key-woman insurance or key-person insurance.
This type of insurance pays out upon the death of a key owner of a business and can used by other business owners to “buy-out” the share of a deceased owner. It can also be used to pay the obligations of the ongoing business that may go unmet due to the death of a key owner of the business. As a condition of financing to provide security for the indebtedness in closely held business, lenders often require the primary owners of a business to obtain “key-man” insurance naming the lender as beneficiary, especially when the business is thinly capitalized.
Other kinds of insurance, such as insurance purchased by an Irrevocable Life Insurance Trust (or ILIT), can provide the funds needed to pay estate taxes (due within 9 months of a key owner’s death) in order to prevent a tax lien on a business owners’ share of a business, not to mention interest and penalties. Such tax liability could in some circumstances even force the sale of the business if there are not liquid assets to pay taxes following the sudden, unplanned for, loss of a business owner.
What is Your Business Worth?
Knowing how much your business is worth is one of the first steps in developing a Business Succession Plan. There are many ways to value a business. A professional business appraiser will be needed to determine the actual value of your business.
Funding Your Succession Plan
The ability to fund the “buy-out” of a business interest is critical to implementing a Business Succession Plan and keeping the business solvent when an owner departs. The transfer of a business interest can be funded, in whole or in part, by life or disability insurance proceeds. It is important that the insurance benefit correspond to the value of the shares of a departing business owner. The life insurance that will be used to “buy-out” the departing owner’s interest can be owned and paid for by the business.
Consider the Following…
- In the event of the death of an owner, what is the impact of estate taxes to your business and your family?
- Do you want to avoid having to sell key business assets to pay these taxes?
- Does the transfer of the business ownership increase tax liability?
- Are capital gains taxes taken into consideration when setting up a Business Succession Plan?
- How will the surviving spouse and family manage if income from the business stops?
- Is the distribution of your business to your family fair? Will there be family disputes?
BUSINESS MANAGEMENT ISSUES
- Who will manage the business interest of a departing owner?
- The business owner’s interest can be paid out in installments, by lump sum, or a combination of both. Which payment method is best for your business?