Buy-Sell Agreements Are Advisable for Businesses with Several Owners

If you're establishing or buying a business with one or more other co-owners, consider implementing a buy-sell agreement to prevent unwanted ownership changes and ensure business continuity if an owner withdraws or dies. A properly drafted agreement can make your business interest more liquid, save taxes and avoid hassles with the IRS. Here's what you should know.  

Buy-Sell Basics

There are two main types of buy-sell agreements:

1. Cross-purchase agreements. When you enter into a cross-purchase agreement, it's a contract between you and the other owners. Under the agreement, the remaining owners must purchase a withdrawing owner's business interest when a triggering event, such as death or disability, occurs. 

2. Redemption agreements. Also known as liquidation agreements, these contracts are between the business entity itself and its owners. Under this arrangement, the business entity must purchase a withdrawing owner's business interest when a triggering event occurs.

To keep the discussion straightforward, we'll assume that there are several other co-owners. However, the same principles apply if there's just one other owner.

Fundamentally, buy-sell agreements serve the following purposes:

• To provide a willing buyer for each owner's interest when a triggering event occurs, 
• To restrict owners from unilaterally transferring their business interests to someone outside the existing ownership group, and
• To ensure favorable tax outcomes for all concerned.

The owners must specify which events will trigger a buyout under a buy-sell agreement. Common triggers include death, disability and attaining a specific retirement age. Other triggering events can be stipulated as you deem appropriate. Examples might include the loss of professional license, divorce, bankruptcy — or simply the desire to cash out of the business.

Valuation and Payment Terms

A buy-sell agreement should stipulate an acceptable method for valuing the business interests covered by the agreement. Common valuation methods include using:

• A fixed per-share price,
• A formula that sets the selling price as a multiple of earnings or cash flow, and
• The interest's fair market value (FMV) as determined by an independent business valuation professional.

Before selecting a valuation method, ensure it meets IRS standards for federal estate tax valuation purposes. The agreement should also specify how and when payments will be made to withdrawing owners or their heirs under various triggering events.

Most buy-sell agreements grant the remaining owners (in a cross-purchase agreement) or the business entity (in a redemption agreement) a right of first refusal to purchase the withdrawing (or deceased) owner's interest. If that right isn't exercised, the withdrawing owner or his or her heirs can sell to an outside party without any further need for permission from the remaining owners.

Using Life Insurance to Fund Buy-Sell Agreement

Triggering events often require significant cash to fulfill the terms of a buy-sell agreement, with an owner's death being one of the most common and the most potentially disruptive events. So, life insurance policies are often used as an agreement's financial backbone.

In a cross-purchase agreement, each owner purchases a life insurance policy on the other co-owners. When an owner dies, the remaining owners collect their tax-free death benefits and use the proceeds to buy the deceased owner's interest from the estate, surviving spouse or other heir. Life insurance death benefit proceeds are free of any federal income tax hit if the surviving owner was the original purchaser of the policy on the other now-deceased owner.

Important: When funding a cross-purchase agreement, don't swap your existing policy on your own life for another co-owner's policy on his or her life. Also, don't designate a co-owner as the new beneficiary of your existing policy on your own life. Doing so can trigger the "transfer for value rule," making the life insurance death benefit fully taxable instead of tax-free.

If possible, each co-owner should purchase a new life insurance policy on each other co-owner. This approach helps avoid the transfer for value issue and ensures that the death benefit proceeds received under the cross-purchase agreement are treated as federal income tax-free.

Cross-purchase arrangements can quickly become complex for businesses with more than two owners because each owner must hold policies on all others. Consider using a trust or partnership to buy and maintain one policy on each co-owner. Then, if an owner dies, the trust or partnership collects the death benefit proceeds tax-free and distributes the cash to the remaining owners. The surviving owners can then use the money to fund their buyout obligations under the cross-purchase agreement.      

To fund a redemption buy-sell agreement, the business entity buys policies on all the owners' lives and uses the death benefit proceeds to buy out the deceased owner.

Note: In a recent controversial U.S. Supreme Court ruling (Connelly v. United States, 144 S. Ct. 1406, 2024), the Court ruled that the value of corporate-owned life insurance used to meet a redemption obligation under a buy-sell agreement should be included in the value of the deceased owner's business interest for federal estate tax purposes without any offsetting reduction for the company's obligation to redeem the deceased owner's interest. This is a negative consideration only if the deceased owner's estate will be subject to the federal estate tax. For 2025, the unified federal estate and gift tax exemption is $13.99 million. In any case, there may not be any workable alternative to using life insurance to fund a buy-sell agreement. Your tax advisor can assess the potential importance of this issue. 

Tax-Saving Advantages

Buy-sell agreements can also help avoid estate tax complications for a deceased owner's heirs. (See "How Buy-Sells Help Create Certainty for Your Heirs," above.) However, the full tax-saving story depends on how your business is structured.

For C corporations. It's generally best to avoid structuring a buy-sell agreement as a redemption agreement. Why? Stock redemption payments are taxed as dividends. Qualified dividends are currently subject to a maximum federal rate of 20%. The 3.8% net investment income tax (NIIT) also may apply.

In contrast, when a C corporation sets up a cross-purchase agreement, it eliminates any risk of dividend treatment. The withdrawing shareholder (or the heirs) subtracts the tax basis of the sold shares from the sale price. Any gain generally qualifies for favorable long-term capital gains tax rates. The maximum federal rate is 20% plus the 3.8% NIIT, if applicable. Also, remaining shareholders receive an additional tax basis in their stock equal to what they pay the withdrawing shareholder (or heirs) under the cross-purchase agreement. With a redemption agreement, they'd receive no such basis increase. For these tax reasons, a C corporation generally should use a cross-purchase arrangement, rather than a redemption arrangement, when setting up a buy-sell agreement.

For S corporations. An S corporation must meet special rules to maintain its S status and qualify for favorable tax treatment. So, an S corporation buy-sell agreement should include restrictions that prohibit shareholders and the corporation from taking the following actions, any of which would terminate the company's tax-favored status:

1. Transferring or issuing shares to a corporation, partnership, ineligible trust or nonresident alien individual,
2. Transferring or issuing shares to a new shareholder if that would violate the 100-shareholder limitation,
3. Revoking a shareholder's U.S. citizenship (or abandoning residence in the United States for resident alien shareholders),
4. Issuing a second class of stock (such as preferred stock), and
5. Voluntarily revoking the corporation's S status unless agreed to by all shareholders.

For partnerships. If the business is a partnership or a multi-member limited liability company (LLC) that's treated as a partnership for tax purposes, consider including a requirement to make a Section 754 election whenever a partner or LLC member's business interest is bought out. Making this election allows the partnership or LLC to increase the tax basis of its appreciated assets. That means bigger depreciation and amortization deductions for the remaining owners and lower taxable gains or income for them when the partnership or LLC sells appreciated assets or collects receivables.

Seek Professional Guidance

A well-drafted buy-sell agreement provides financial protection to you and your heirs. The same is true for the other owners and their heirs. The agreement can also help minimize income taxes and avoid estate tax hassles with the IRS. However, buy-sell agreements aren't do-it-yourself projects. Get your help from your tax and legal advisors.