Entity Purchase Buy-Sell Agreement
A buy-sell agreement obligates one party to purchase a deceased business owner's interest at a certain price, and another party-the deceased owner's estate or heirs-is obligated to sell the interest at that price. Under an entity type of buy-sell agreement, the business entity, not the individual owners, agrees to buy the interest. Under another type, the cross-purchase agreement, each business owner individually agrees to buy a portion of the deceased owner's interest. A buy-sell agreement gives business owners certainty about who will purchase the deceased owner's business interest, what the price will be, when the sale will take place, and where the funds will come from. The entity buy-sell agreement is funded by life insurance covering the life of each owner. The amount of insurance approximates the purchase price for the insured's share of the business. The purchase price is either specified as a certain fixed amount, or the agreement includes a formula to be used to establish the price. The business entity owns the policies and is the beneficiary of each. If an owner dies, the business receives the life insurance proceeds, which it uses to buy out the deceased owner's interest. An entity agreement is preferred over a cross-purchase agreement when: - There are many owners. The business owns just one policy for each owner. (With a cross-purchase agreement, each owner owns a policy on every other owner.)
- There is a wide disparity in ages of the owners. (With a cross-purchase agreement, younger owners pay high premiums for policies on older owners.)
- The business wants policy cash values to be available as reserve funds for the business entity, which would not be possible under a cross-purchase agreement.
- Premiums paid for life insurance to fund the buy-sell agreement are not tax-deductible, but the death proceeds are generally exempt from federal income tax.
Some C corporations may be subject to corporate alternative minimum tax on part of the proceeds. If a corporate stock redemption agreement is used, there is no increase in basis for a surviving owner's interest as there is with a cross-purchase agreement. Distributions from a corporation to a shareholder are generally taxed as dividends, but dividend treatment can be avoided if the stock redemption qualifies as one of certain exempted transactions. The price established for a business interest in a buy-sell agreement can fix the value for federal estate tax purposes if strict legal requirements are met. This price can be based on a professional appraisal or formula that takes into account, among other things: - The earnings history and future earnings potential of the business
- The book value of the company's assets and the general financial condition of the business
- Any prior sales of interests in the business
- Goodwill, and
- The outlook for the economy in general and for the specific industry.
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