What is a Buy-Sell Agreement? Safeguard Your Business with This Critical Plan

As a business owner, you know things don’t always go exactly as planned – and you’ve learned how to pivot and adapt to unexpected situations.

But for all your business savvy and strategic forecasting, one thing you might not be prepared for is the unthinkable: What would you do if your partner or an owner in your small, closely-held business unexpectedly passed away without time to prepare?

An event like this can throw your business off balance, and many owners overlook the critical planning needed to navigate it. As much as we don’t want to think about the major Ds of life (Death, Disability, Divorce, and Disagreement), just because they’re not on your radar doesn’t mean they won’t happen.

That’s where a buy-sell agreement comes in. These critical agreements play a major role in the longevity and health of your business when any of the major Ds come your way.

While a buy-sell agreement is essential for navigating any major life change or event in a business, we will focus primarily on one of the most disruptive and potentially sudden events: death. Let’s dive in!

What is a Buy-Sell Agreement?

A buy-sell agreement is a legal agreement that determines what happens to the owner’s shares if they pass away.  Under a buy-sell agreement, the surviving owners may have the option or contractual obligation to purchase the deceased owner’s shares in the ownership of the business.

Why does this opportunity to purchase shares matter to the surviving business owners?

In practice, buy-sell agreements give business owners the first right of refusal for a deceased or incapacitated co-owner’s shares. It prevents a scenario where they could ultimately lose control over a portion of the business when the unforeseen strikes.

There are several basic components to a buy-sell agreement. It starts by defining a triggering event such as death, disability, or retirement. At this stage, there should be a valuation of the business and clear instructions for determining the value of ownership. The agreement outlines who can buy the shares that are up for grabs including co-owners, family members, or external parties. It also covers funding the buyout through life insurance, savings, and other means.

The mechanics of your agreement depend on whether it is a cross-purchase buy-sell agreement or an entity-purchase agreement. We will take a closer look at both.

Cross-Purchase Agreement

In a standard cross-purchase buy-sell agreement, transactions take place between each owner. When a death occurs, the deceased partner’s stake is sold directly to other owners of the business.

But how can they afford to cover the cost of the stake at a moment’s notice? After all, many of us have no inkling when death is on our doorstep.

Most often, the buy-out is funded using a life insurance policy. Each owner owns a policy on each of the other owners. Payouts upon death create liquid funds to fulfill the buy-sell agreement.

Unfortunately, this can get very complex in a business with more than two or three owners. For example, a business with five owners would require twenty life insurance policies! With so many parties involved, maintaining the agreement and sufficient life insurance coverage is more difficult than imagined. You may face some unexpected changes over time as the value of the business changes, which requires nimble moves to protect the agreement.

Think about it this way: Suppose an owner enters or exits the business. As ownership changes hands, you will also have to take out new life insurance policies. On the other hand, the value of the business may change, necessitating an alteration to the coverage of your life insurance policy. The entire ordeal can result in more than just one policy for each other owner.

The inherent problem is that it gets incredibly expensive for individual owners to own insurance on one another, especially if the other owners are older or have health conditions that increase the cost of insurance. The business could reimburse these expenses, but it increases taxable income to the owners.

Entity-Purchase Agreement

An entity-purchase agreement (also called a stock redemption) is another option. In this scenario, transactions are handled at the business level, not among individual owners. When one owner dies, their stake is then purchased by the business itself, funded using life insurance that is owned by the business. The business is the beneficiary of the policy, creating liquid funds to fulfill the agreement without the business dipping into cash reserves or seeking a loan.

This is far less complex if your business structure consists of several owners. The major difference lies in how many policies you need to take out. If your business has five owners, you will need five policies (compared to the twenty you would need in a cross-purchase agreement).

There are still downsides to an entity-purchase agreement. Most notably, the surviving owners do not receive a step-up in basis of the deceased owner’s shares. Typically, an asset owned by a deceased person receives a step up in cost basis equal to the fair market value as of the date of death.

From a personal planning standpoint, you should be aware that the Supreme Court recently ruled in Connelly v. IRS that life insurance proceeds paid to an entity in an entity-purchase agreement increase the business’s value when determining the taxable estate of the deceased owner.

This is critical to understand as current estate exemption amounts of $13.61M per individual in 2024 will likely sunset to about 50 percent of its current value after 2025. With amounts above the exemption amount taxed at 40 percent, careful attention should be paid to the size of current ownership stakes and the amount of the death benefit value included in the taxable estate.

Why a Buy-Sell Agreement is Essential

A buy-sell agreement ensures smooth ownership transitions and clarity about the ownership of the business moving forward. Without this important piece in place, an owner’s shares could instead transfer to their heirs based on their estate plan. Even without estate documents, like a will or trust, in place, state law may require the shares to transfer to their heirs without a buy-sell agreement.

Unless the deceased had a succession plan in place for them, these heirs may not be prepared or interested in running the business, and thus less likely to ensure its future success. It can also trigger conflict among existing owners.

Life insurance policies tied to buy-sell agreements can help businesses maintain financial integrity. Suddenly having the expense of buying out a partner or another owner is difficult to navigate under even the best circumstances. If resources are not plentiful or credit and financing are not available to facilitate the purchase, surviving owners could be at a huge disadvantage.

An ownership stake in a business might be one of the most significant—and most illiquid—assets in an estate. Heirs are far more likely to want liquidity if they are not a part of the succession plan as owners, especially if they require cash for final expenses or taxes.

For heirs who are counting on liquid funds to cover the costs of an unexpected death, it might lead them to force the sale of shares at a discounted valuation so that they can cash in. The result is that they may get less than fair market value for their ownership stake.

On top of it all, navigating the sale of shares while mourning can be extremely unpleasant. Putting a buy-sell agreement in place provides your family comfort and peace of mind while simplifying the handling of your estate.

Be Prepared with a Buy-Sell Agreement

Without a buy-sell agreement in place, you run the risk of losing control over the ownership of the business which could be disruptive for all stakeholders. You will already be grieving the loss of a dear friend, business partner, or even a family member. Why compound those issues with the stress of an unclear business succession plan or lack of funds to execute on the plan?

Don’t leave your success to chance or risk chaos in the face of the unexpected. At Monument Wealth Management, we specialize in helping business owners like you consider multiple angles, minimize your risks, and find new opportunities to build wealth with purpose.

Through co-creating your personal Private Wealth Design, we help you achieve a deep understanding of the big picture and what matters most to you – so you can feel confident with the legacy you’ve built no matter what the future may hold.