Buy-Sell Agreements: Protecting Business Continuity and Setting the Tax Value

Buy-sell agreement types and tax consequences:

Cross-purchase agreement:

• Surviving owners buy the departing owner’s interest directly
• Funded by life insurance owned by each co-owner on the other co-owners’ lives
• Tax benefit: surviving owners get a stepped-up basis in the purchased interest
• Complexity increases with more owners (n owners require n x (n-1) policies)
• Best for: 2-3 owner businesses

Entity redemption (stock redemption for C/S-Corps):

• The business buys back the departing owner’s interest
• Funded by life insurance owned by the business
• Tax consequence: surviving owners do NOT get a basis step-up (the business used its assets to buy out the departed owner, and the remaining owners’ basis does not change)
• Simpler for multiple owners (only n policies needed)
• Best for: businesses with many owners, or where simplicity is preferred

Hybrid (wait-and-see):

• Gives the entity the first right to purchase, with remaining owners having the right to purchase any interest the entity does not acquire
• Provides flexibility to optimize the tax result at the time of the event
• Most common structure recommended by advisors

Valuation methods:

• Fixed price: Set a specific dollar value, updated annually. Simple but often becomes stale.
• Formula: Revenue multiple, earnings multiple, or book value. Self-updating but may not reflect true market value.
• Appraisal: Independent valuation at the time of the event. Most accurate but adds cost and delay.
• IRS scrutiny (IRC 2703): The IRS may disregard the buy-sell price for estate tax purposes if: the agreement was not entered into at arm’s length, the terms are not comparable to similar arrangements, and the agreement is a device to transfer the interest for less than full value.