by Nate Putnam, CFP®
Vice President
Portfolio and Wealth Management
For business owners, planning for the future transition of their business is crucial. Succession planning isn't just about deciding who will take over when you retire; it’s also about ensuring a smooth transition if something unexpected happens. This is where buy-sell agreements can be beneficial.
What is a Buy-Sell Agreement?
A buy-sell agreement is essentially a contract between the owners of a business. It outlines what happens to an owner's share of the business upon a specific triggering event such as death, becoming incapacitated, or retirement. The buy-sell agreement can ensure that the remaining owners have control over who buys the shares, reduce conflicts and ensure the business remains in capable hands.
There are two main types of buy-sell agreements: cross-purchase agreements and entity-purchase agreements. Both have their own unique mechanics and implications.
In a cross-purchase agreement, individual owners agree to buy each other's shares if one of them can no longer continue in the business or unexpectedly passes away. Typically, each owner buys life insurance policies on the other owners, with the insurance payout providing the funds needed to buy the deceased owner’s shares in the event of death.
In an entity-purchase agreement, the business buys life insurance policies on each owner and receives the proceeds itself, in turn buying out the departing owner's shares in the event of death.
Pros and Cons of Each Agreement
While both types of agreements aim to ensure the effected owner's estate gets fair value for their shares and that the remaining owners maintain control, there are important differences. A cross-purchase agreement can be simple with only a few owners but gets complicated with more owners. For example, in a company with four owners, there would need to be 12 life insurance policies purchased (four owners buy a policy on each of the other three owners). Thus, an entity-purchase is often simpler with many owners, as the business only needs one policy per owner.
The cost of each type of agreement is also important to consider. In a cross-purchase agreement, life insurance costs can vary significantly based on each owner's age and health, resulting in different premiums for each of the policies.
Given these factors, entity-purchase agreements have historically been favored, especially for businesses with many owners.
The Impact of the Recent Connelly v. IRS Ruling
A recent legal decision, coming from Connelly v. IRS, has added new wrinkles to entity-purchase agreements with significant potential estate tax implications. The U.S. Supreme Court ruled that life insurance proceeds received by a business in entity-purchase agreements increase the business's fair market value for estate tax purposes. This can significantly impact the taxes owed by the deceased owner’s estate.
In the case of Connelly vs IRS, Michael Connelly owned roughly 77% of his business. Upon his death, the business received and used the proceeds from a $3 million insurance policy to buy his shares. The IRS argued that the business’s value should include the insurance proceeds received by the business, raising the total value of the business by roughly $3 million, and resulting in a much larger estate tax bill for Mr. Connelly’s estate.
The ruling means that insurance proceeds received and used in entity-purchase agreements count towards the business's valuation for estate tax purposes. Given the historical prevalence of entity-purchase agreements, the size of life insurance policies needed to fund these buyouts, and the scheduled reduction of the federal estate tax exemption in 2026, this case may impact the estate tax liability of many business owners.
Like many elements of legacy planning, we urge business owners to carefully review and understand their buy-sell agreements with their tax and legal advisors, particularly if you are using an entity-purchase agreement and evaluate whether any adjustments may be needed.
Please reach out to your planning team at Ferguson Wellman & West Bearing Investments for any planning questions you may have or for an introduction to a legal professional to assist with reviewing your succession planning arrangements.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.