By: Randall A. Denha, J.D., LL.M.
If someone operates as the sole owner of a business, regardless of the form of entity, a special problem arises when the owner dies, retires, becomes disabled or decides to leave the business. Unlike a business with co-owners who can buy out the owner’s interest upon any of the foregoing events, the owner stands to lose all of the value built up in the business over many years of hard work. In fact, other problems exist as well. The owner or surviving family members may lose a source of income. Faithful employees may be out of work or choose to leave. Vendors, banks and other creditors may want to be paid off. Receivables may be difficult to collect. What is the best option for a sole owner of a business in light of all of these potential issues? The One-Way Buy-Sell Agreement may be the solution.
A Potential Solution:
If you can identify a potential purchaser – ideally from among your family members, valued employees or even a friendly competitor – a simplified type of “buy-sell agreement” often referred to as a “one-way” buy sell agreement could be used to facilitate your business succession plan. In this scenario, you would contract to sell – and the purchaser would contract to purchase – your business ownership interest upon the occurrence of a specified event (e.g., retirement, death, or disability). The purchase price can either be a fixed value or established by way of an independent appraisal, multiple of earnings approach or other method. In fact, this value can be revisited each year and recalculated from time to time. The agreement may also provide that the purchaser would not assume the debts and obligations of the business. Your executor would use cash from the purchase to payoff business obligations and, if applicable, other costs, taxes, and administrative expenses of your estate. The balance of the proceeds would then be distributed under the terms of your estate plan to your estate beneficiaries.
Funding the One-Way Buy-Sell:
The purchaser typically acquires a life insurance policy on your life sufficient to meet the payment obligations under the agreement. The purchaser would be the owner and beneficiary of that policy. The purchaser would likely be required by the agreement to maintain the policy through premium payments and to notify your prior to exercising any policy rights that might affect its value. If the purchaser is also obligated to purchase the business if you become disabled, the purchaser often will want to insure this obligation as well.
The buyer often has a “right of first refusal” on any lifetime disposition of the business by the owner. This means that the owner must first offer the business to the buyer before selling it to a third party during the owner’s life, including at retirement. Only after the buyer declines the option can the owner pursue a sale to a third party. In other words, the death buyout required under the agreement can’t be defeated by the owner’s lifetime disposition of the business, provided the purchaser exercises the option to buy. While this clearly restricts the owner’s freedom, it assures the buyer that he or she will not pay the insurance premiums in vain.
Summary of Transaction:
The owner of a business enters into a buy-sell agreement with a non-owner under which the owner agrees to sell, and the non-owner agrees to purchase the business upon the owner’s death (and possibly other triggering events), and at a price specified in the agreement.
The non-owner purchases life insurance on the life of the owner and names himself/herself as the beneficiary to assure that he/she will have the funds to purchase the business at the owner’s death. When the owner dies, the non-owner receives the death proceeds of the policy.
The non-owner uses the death proceeds to carry out his/her purchase obligation under the “one-way” buy-sell agreement. The owner’s estate transfers ownership of the business interest to the non-owner who becomes the owner.
In the event of a lifetime sale, the buyer can make the purchase in installments, providing it’s structured to comply with the Internal Revenue Code’s installment sale rules. This could be particularly useful in the case of a lifetime purchase, when only the policy’s cash value—not the full death proceeds—is available to the buyer. With an installment sale, the buyer could then use the net income from ongoing business operations to help carry out the purchase. And for the owner, it can spread any taxable gain from the sale over the installment payment period instead of being bunched into one tax year.
Clearly, a one-way buy-sell agreement is an effective way to resolve the many problems that can otherwise affect a one-owner business. The key is to find a willing buyer to complete the agreement— ideally someone already employed by and familiar with the business.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.