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Choosing a funding method for your buy-sell agreement

Published on 4/29/2016
Written by: Paul Bogdanoff, CPA

Anyone who owns a closely held business with at least one other partner needs to take certain steps to guard against business disruption. If one partner departs suddenly, or becomes disabled or dies, serious confusion and conflicts can ensue. Among the most important steps is to create a buy-sell agreement, which stipulates precisely how ownership interests will be valued and purchased.  It is advisable that the drafting of a buy-sell agreement should be done during the initial set up of the company, along with the company’s By-Laws or Operating Agreement.

2 ways to pay

In most situations, payouts for a buy-sell agreement are funded with a cash-value life insurance policy or a disability buyout insurance policy. There are two main types of life insurance-funded buy-sell agreements:

1. Cross-purchase agreement. Partners buy insurance policies on each other, using the proceeds to buy a deceased or disabled partner’s ownership shares. They receive a step-up in cost basis that may reduce taxes if the business is later sold. This option is usually preferable if there are three or fewer business partners.

2. Entity purchase agreement. The business entity buys insurance policies on each partner and uses the proceeds to buy a deceased or disabled owner’s shares, which are divided among surviving partners. Partners receive no step-up in cost basis with this type of agreement. This option is usually preferable if there are four or more partners, because it eliminates the need for each partner to buy so many insurance policies. 

Business valuations

It’s usually wise to hire a professional business appraiser to perform a business valuation when drafting a buy-sell agreement. The valuation should then be updated periodically as circumstances that could potentially affect the value of the company change. In fact, the buy-sell agreement itself should be reviewed by all of the partners from time to time to make sure it still reflects each partner’s intentions and the funding is in place to meet an unexpected buy out.

Business valuation formula

Another method to value a business is to develop a formula that will be used to value the business that is agreed to by the owners.  A multiple of sales or cash received over a period of time are examples of formulas that are commonly used. 

Other considerations

Life insurance agents may have access to templets of either a cross purchase or entity purchase agreement that may be used to create the agreement.  However, it is always a good idea to have the agreement reviewed by the company’s lawyer. 

During this process the business owners should also keep in mind how to buy out an owner that leaves the Company.

An important step

Creating a buy-sell agreement is an important step in the growth and preservation of every business. For help creating or reviewing yours, please call Tim or Paul at Bogdanoff Dages and Co., P. C.