A corporation, with family or small group of shareholders there is a concern about what might occur if one of the owners dies becomes disabled or becomes divorced. If these events occur, will the shareholder’s family retain the corporate interest? Can the surviving owners avoid interference from that shareholder’s family? Will the survivors have the ability to redeem that shareholder’s interest? Given these concerns, shareholders are best served by entering into a buy-sell agreement while they are all alive, and there are no problems confronting them.
The Three Types of Buy-Sell Agreements
A Buy-Sell Agreement is a written agreement among the shareholders of a company in which each owner agrees that upon the occurrence of a trigger event, such as a death, divorce or disability their shares will be sold to the surviving owners at an agreed upon price and terms. The three types of Buy-Sell Agreements include:
Cross Purchase Agreement:
With a cross-purchase agreement, each owner of the corporation purchases an insurance policy on the other shareholders. The purchaser is both owner and beneficiary of the policies. Upon the death of a shareholder, the other shareholders are then able to use the life insurance proceeds to purchase the deceased owner’s shares. The family of the deceased owner will have a tax basis equal to the fair market value of the decedent’s stock at the date of death, thus avoiding any income tax consequences as a result of the sale. The fair market value of the shares should be defined by the buy-sell agreement. However, the shareholder will receive a bonus equal to the annual premiums for the insurance policy which will be treated as compensation. This plan can be difficult to manage if there are a large number of shareholders.
With a stock redemption agreement, is when the corporation owns policies on the lives of the shareholders. When a shareholder dies, the corporation buys the deceased shareholder’s interest in the company with the insurance proceeds. An advantage of the stock redemption agreement is that it is easier to administer for multiple shareholders. An additional advantage to the stock redemption structuring of the buy-sell agreement is that the corporation will bear the premium differences associated with age disparities among shareholders. A significant disadvantage of the stock redemption form of the buy-sell agreement is that the remaining shareholders do not get the benefit of a step-up in basis when the corporation purchases the deceased shareholder’s interest. The continuing shareholders retain their original bases in the company.
With a Hybrid agreement you use a combination of cross purchase and stock redemption which require the remaining owners and business to purchase the interest of that shareholder.