When you’re starting or growing a business with a partner, drafting a buy-sell agreement isn’t as much fun as your next big sales pitch, but it should be a top priority. it is an agreement that protects you and the business if something happens to you or your partner.
“Unless you have a buy-sell agreement, you may be sharing the reins with a former partner’s spouse, children, or someone else who knows little about your business and isn’t as interested in its success as you are. says john muth, director of advanced planning at northwestern mutual. “However, that scenario often plays out because trading partners never created or financed a deal in the first place, or because the one they have is outdated.”
A buy-sell agreement is basically an exit strategy for you and your business partners. can help protect you and your family by setting ground rules for how ownership actions should be handled in the event that you or one of your partners leaves the business.
Here are four things to keep in mind when establishing or reviewing a buy-sell agreement.
- Know how much your business is worth
A buy-sell agreement establishes a fair value for your shares of ownership using a valuation formula, such as a multiple of earnings or sales, or setting a value directly.
“Having a valuation of your business can help avoid potential conflicts down the road if a former business partner or your beneficiary demands more for your ownership shares than you think they’re worth,” says Muth. “And updating your valuation periodically also provides a way to track the growth in value of your business for your own personal financial and estate planning purposes.”
- Deciding on a Structure
Buy-sell agreements take many forms, but most fall into one of two structures: an entity redemption plan or a cross-purchase plan. With an entity redemption plan, the business entity itself is obligated to purchase or redeem the property interests of an outgoing owner. With a cross-purchase plan, each surviving owner agrees to purchase a specific percentage of the outgoing owner’s interest.
- Make Sure You Finance It
If you ever need to act on your buy-sell agreement, money will change hands. that means you need a plan for where that money will come from. sources can include cash, a sinking fund, installment payments, or a loan. however, many business associates find life insurance to be the most tax and cost effective way to have money available in the event the owner goes out of business.
“With an entity redemption agreement, the company purchases separate life insurance contracts on the life of each owner, pays the premiums, and is the owner and beneficiary of the contract. When an owner dies, the company uses the income tax-free death benefit to buy the shares of the deceased owner,” explains Muth. “With a cross-buy buy-sell, each owner buys a policy on the other owner. when one of the owners dies, the surviving owners use the death benefit to buy the shares of the deceased owner.”
life insurance financing options
You can finance a buy-sell agreement with term or permanent life insurance. each has its own benefits, muth says.
Term insurance provides temporary coverage for a specified period of time and does not have a cash value component. however, initial premiums may be lower than they would be for a comparable amount of permanent life coverage.
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“this can make term insurance an attractive option if your business has limited cash flow, specific budget constraints, or if you need coverage only for a known period of time, for example, because you plan to sell the business or a partner plans to sell it. retire in the not-too-distant future,” muth says.
Permanent life insurance, on the other hand, offers lifetime protection. In addition to the death benefit it provides, permanent life insurance also builds guaranteed cash value. that money can be accessed to fund all or part of a buy-sell agreement, should you or one of your partners leave for a reason other than death.
“When you retire, you may be able to transfer ownership of your life policy and take the policy with you. That would allow you to name your own beneficiary for the death benefit and use any accumulated cash value to supplement your retirement income, fund a new business, or do whatever you want,” Muth says.
added that there may be tax implications with transferring your policy, so be sure to check with your tax advisor first.
A well-designed and properly funded buy-sell agreement can give you peace of mind knowing that your business and family will be protected if something happens to one of your partners. If you think a buy-sell agreement could benefit you and your business, consult your financial professional for more information on how to move forward and coordinate with your attorney to draft the buy-sell agreement.
This publication is not intended to be legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.