A co-owner of a closely held family business should carefully consider what would happen to the business in the event of his or her death or the death of a co-owner. Many issues come to mind, including whether the business would be able to survive. Family members might find it necessary to liquidate the business to pay taxes and expenses. Many practical questions also arise. For example, can the surviving owners afford to buy the deceased owner’s interest? How the business entity is configured — whether as a partnership, limited liability company, or corporation — could also play a pivotal role in deciding how the disposition of a business interest will be handled.

A buy-sell agreement is often a key component of business succession planning for small business owners. It sets forth terms for the purchase of a deceased owner’s business interest by the company or the surviving co-owners. Funding is a critical issue that requires careful planning and, commonly, life insurance proceeds are used to fund purchases under buy-sell agreements.

Valuation Benefits

A properly structured buy-sell arrangement can accomplish more than simply determining the terms under which a deceased owner’s interest will be transferred to the business or surviving owners. It can also help fix the value of the business interest for federal gift- and estate-tax purposes — as long as the arrangement is bona fide and not used as a device to transfer the business to family members at less than full value.

Where a buy-sell arrangement is used for purposes of transferring a business interest between family members, it is critical that the purchase price be set based on a valuation conducted by an unrelated, highly qualified appraiser. Otherwise, the IRS may determine a value that is not advantageous for tax purposes.

Three Basic Types

There are three basic types of buy-sell arrangements.

Cross purchase. A cross purchase agreement is structured so that the owners agree to purchase each other’s share of the business in the event of an owner’s death. Purchasing co-owners will have a tax basis equal to the price they pay for a deceased owner’s interest. This step-up in basis is advantageous in that it may reduce the co-owner’s tax liability in the event of a subsequent sale of the acquired business interest.

Redemption. A stock redemption agreement provides that the corporation will buy the deceased owner’s shares. A key difference between a cross purchase and stock redemption arrangement is that the surviving shareholders receive no step-up in basis for the shares acquired in a redemption.

Hybrid. The third variety of buy-sell agreement is a hybrid, or combination, arrangement. This structure incorporates elements from both the cross purchase and stock redemption varieties. One such arrangement involves individual owners agreeing to buy some of a decedent’s shares, with the company buying the remaining shares. Another possibility is to have a right of first refusal drafted into the buy-sell agreement. This provides the surviving owners with the choice as to whether they want to purchase the deceased owner’s shares.

A buy-sell agreement can be tailored to your particular business situation. If you currently have a buy-sell agreement in place, it may be wise to have it reviewed to ensure that it is still appropriate under your specific circumstances.

Ken Meissner, CPA is a partner at Alegria & Company and specializes in business and personal income tax and is a Certified Specialist in Estate Planning.

He can be reached at kmeissner@alegriacpas.com