A buy-sell agreement is a legally binding contract among business owners that dictates how a partner’s or shareholder’s interest in the business will be handled upon certain triggering events. These agreements maintain business continuity and stability. There are several types of buy-sell agreements, but two of the most common are the cross-purchase agreement and the entity purchase (or redemption) agreement. This article will focus on the entity purchase plan, explaining when and why it is used.
Understanding the Entity Buy-Sell Agreement
The entity buy-sell agreement is an arrangement where the business itself (the entity) agrees to purchase the ownership interest of a departing owner. This is in contrast to a cross-purchase agreement, where the remaining owners agree to purchase the departing owner’s share. The entity agreement is typically funded by life insurance policies owned by the business on the lives of the owners. When a triggering event occurs, the business uses the proceeds to redeem the shares.
When is an Entity Buy-Sell Agreement Used?
Entity buy-sell agreements are most commonly used in businesses with a large number of owners or shareholders. When there are many owners, a cross-purchase agreement becomes administratively complex because each owner must maintain and pay premiums on policies for every other owner. For example, in a business with 10 owners, a cross-purchase plan requires 90 separate insurance policies (N (N-1)). An entity plan, however, only requires 10 policies—one policy held by the business on each owner.
The entity plan is also frequently used when the owners want the business to bear the financial burden of the buyout. Since the business entity pays the premiums and receives the proceeds, the cost is spread across the company’s finances rather than falling directly on individual owners. This can be particularly appealing if the owners have varying personal financial situations.
Furthermore, entity agreements are often preferred when the goal is to ensure that the departing owner’s interest is completely eliminated from the ownership structure, thereby consolidating ownership among the remaining parties without requiring them to personally fund the purchase.
Triggering Events for Entity Buy-Sell Agreements
An entity buy-sell agreement must clearly define the events that will trigger the mandatory or optional sale of an owner’s interest back to the company.
Death
The most common triggering event is the death of an owner. The life insurance policy funding mechanism provides immediate liquidity to the business to purchase the deceased owner’s shares from their estate. This ensures a smooth transition of ownership and provides financial security to the deceased owner’s family.
Disability
If an owner becomes permanently disabled and can no longer contribute to the business, the agreement may trigger a buyout. The definition of “disability” must be precise, often requiring a waiting period (e.g., 6 to 12 months) before the buyout is initiated. This prevents premature buyouts based on temporary illness.
Retirement
When an owner decides to retire, the agreement often mandates the sale of their interest back to the entity. The terms of the buyout, including valuation and payment schedule, are usually detailed within the agreement itself.
Voluntary or Involuntary Termination
This covers situations where an owner wishes to leave the business voluntarily or is terminated involuntarily (e.g., due to breach of contract or bankruptcy). The agreement specifies whether the entity has the right or obligation to redeem the shares in these circumstances.
Advantages of the Entity Buy-Sell Agreement
The entity purchase agreement offers several distinct advantages over the cross-purchase method.
Administrative Simplicity
The primary advantage is the reduced administrative burden. The company manages fewer insurance policies and handles all the paperwork related to the funding and execution of the agreement.
Equalization of Cost
The cost of funding the agreement (insurance premiums) is borne by the business, which effectively spreads the cost among all owners based on their ownership percentage. This ensures that owners with smaller stakes do not have to shoulder disproportionately high premium costs, which can sometimes happen in cross-purchase plans if there are significant age differences among partners.
Guaranteed Funding
Using life insurance ensures that the funds are immediately available upon the death of an owner, guaranteeing that the buyout can be executed promptly without requiring the remaining owners to scramble for financing.
Disadvantages and Considerations
Entity agreements present certain disadvantages, primarily related to tax implications and corporate structure.
Tax Implications (Basis Issues)
A significant drawback is that when the entity redeems the shares, the remaining owners do not receive an increase in their tax basis in the company. In a cross-purchase agreement, the remaining owners purchase the shares directly, increasing their basis, which can reduce future capital gains tax liability upon the eventual sale of their own interest.
Corporate Alternative Minimum Tax (AMT)
If the business is structured as a C-corporation, the receipt of large life insurance proceeds upon the death of an owner may trigger the Corporate Alternative Minimum Tax (AMT), potentially reducing the net amount available for the buyout.
Surplus Requirements
In some states, corporate law requires that a corporation have sufficient earned surplus (retained earnings) to legally redeem its own shares. If the company lacks the necessary surplus, the agreement may be unenforceable, even if insurance proceeds are available.
Structuring and Funding the Agreement
The agreement must clearly define the valuation method for the business interest. Common methods include a fixed price (which must be updated regularly), a formula based on earnings (e.g., multiple of EBITDA), or an appraisal process.
Funding is usually achieved through life insurance. The business owns the policy, pays the premiums, and is the beneficiary. The amount of coverage should ideally match the agreed-upon valuation of the owner’s interest. If the valuation exceeds the insurance coverage, the agreement must specify how the remaining balance will be paid (e.g., installment payments over time).
Conclusion
The entity buy-sell agreement is an administratively simple tool, particularly suited for businesses with many owners. It ensures business continuity by providing a clear, funded mechanism for the transfer of ownership upon triggering events like death, disability, or retirement. Owners must carefully consider the tax implications, particularly the lack of basis step-up for remaining owners, and ensure compliance with state corporate surplus requirements. Consulting with legal and financial professionals is essential when implementing this business planning document.