4 Methods of Using Buy-Sell Agreements

There are many different ways to be protected by a life insurance policy. This article gives you 4 different methods to add to your existing policy. Buy-sell agreements can take a number of forms based on the tax and other objectives and circumstances of the parties to the contract:

Stock redemption – In this type of buy-sell arrangement, the business itself purchases the shareholder’s interest upon the triggering event, preferably according to a formula-determined price. With respect to any insurance, the corporation should be the applicant, owner, beneficiary, and premium payer. This arrangement is sometimes called an entity purchase.

Cross purchase – In this type of arrangement, the remaining business owners buy the business interest upon the triggering event, preferably under a formula-determined price. With respect to any insurance, the shareholders should be the applicants, owners, beneficiaries, and premium payers. This arrangement is sometimes called a criss cross.

Wait and see – This highly flexible approach allows planners to defer the decision regarding the eventual purchaser until a triggering event occurs. It is appropriate when the corporation or surviving shareholders may not have sufficient funds to purchase a decedent shareholder’s stock alone, when the client’s advisers seek more flexibility in light of rapidly-changing tax laws and client circumstances, or when the client’s advisers seek an escape hatch to avoid adverse income tax consequences. Mechanically, the wait and see buy-sell works as follows:

The corporation is given a first option to purchase any or all of the exiting shareholder’s stock. At this stage, the wait and see buy-sell takes the form of a stock redemption plan. To the extent that option is not exercised within a designated period, the parties enter Stage B.

At this stage, the remaining shareholders are given an option to purchase the stock. Here, the arrangement is similar to a cross purchase plan.

Any stock remaining at the expiration of the second option must be purchased by the corporation. In this final stage, the purchase takes the form of a stock redemption.

The order of the three stages is important. If the parties were reversed and the corporation were to purchase shares under option (b), relieving shareholders of an obligation to purchase stock under option (c), the IRS would classify the payment by the corporation as a constructive dividend.

The insurance policies that fund the wait and see can be arranged in a number of ways. The corporation could purchase a policy on the life of each shareholder and use the proceeds to finance its purchase of stock from a decedent-shareholder’s estate, to effect a Section 303 partial stock redemption, or to loan the proceeds to the surviving shareholders in order that they might purchase the decedent’s shares under option (b). The shareholders could purchase the insurance as under a cross purchase plan and, if they choose not to purchase the decedent’s shares themselves, loan the proceeds to the corporation or make additional capital contributions to the corporation, thus increasing their basis in their own stock. Finally, a third party, such as an irrevocable trust, could purchase the insurance as a means of keeping the proceeds out of the decedent’s estate.

Third party buy-out (a.k.a., a unilateral or one-way buy-out) – A third party agrees contractually to purchase the business interest upon a triggering event.

Example. Joe and Paul, two brothers, have operated a highly successful auto repair and parts business. Joe runs the day-to-day operation of the business and makes the long-run hiring and firing decisions. Paul, the younger brother, is the super salesman who “makes things happen.”

Joe knows that either brother would have a difficult time continuing to run the business at its present level if the other brother died (or became permanently disabled). Furthermore, both brothers know their stock is worth in excess of $3 million and will therefore generate considerable federal estate tax when added to their other assets. Both brothers realize their families are dependent on their annual salaries of $300,000 a year, salaries which would stop at their deaths.

Joe and Paul have their attorney draft a “wait and see” buy-sell agreement which provides that if either brother dies, either the corporation or the surviving shareholder will purchase the stock of the decedent and in return pay the estate the full fair market value of the stock in cash.

To finance the purchase upon either brother’s death, each brother purchases a life insurance policy on the life of the other. To help them with the premiums, the corporation can agree to pay each brother a sufficient bonus so that, after taxes, each will net an amount large enough to pay policy premiums. Alternatively, the corporation might enter into a split dollar agreement with the brothers to help them pay the premiums. 

The decedent’s family will no longer be tied to the economic success of the business, will not need to bother the surviving brother, and will not be able to interfere in the operation of the business. The surviving brother will have no debt to his late brother’s family and will enjoy 100 percent of the financial rewards for his increased burdens.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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