You must also put a funding plan in place to ensure the buyers have the available funds to purchase the business according to the terms of the buy-sell agreement. This ensures the buyer won't have to sell assets, take out loans, or file for bankruptcy in order to honor the buy-sell agreement.
Many buy-sell agreements are funded by life insurance. Under this funding plan, you and your business partners would take out life insurance policies. The company pays the premiums, owns the policy, and is the beneficiary. When a partner dies, the life insurance policy funds the buyout of that partner's business interest. Under other arrangements, such as a cross-purchase agreement, partners take out life insurance policies on other business interest holders, and pay the premiums themselves. Whether the life insurance policies are owned by the business or by individual shareholders affects how the buy-sell agreement is structured and carried out.
Note: If you are using life insurance to fund your buy-sell agreement, it is imperative that you do not let the policy lapse for any reason. Discontinued coverage can affect the validity of the buy-sell agreement.
There are also other ways to finance buy-sell agreements, including:
Cash. This method can pose difficulties, because the buyer may not be able to adequately plan for having enough money on hand to fund the buyout, especially if it occurs unexpectedly. This can also severely deplete a surviving business partner's or family members' liquid assets, putting the business in jeopardy.
Borrowing (loans, lines of credit, etc.). Keep in mind that the buyer must be able to qualify for loans, and that financial institutions may be reluctant to lend money to a business that has just lost a key player.
Installment agreements that allow the business interest to be purchased over time. Payment agreements must be structured carefully to avoid tax issues. Also, the longer the agreement, the higher the financial burden placed on the buyer.
Self-canceling installment note. This allows you to transfer the business to a buyer in exchange for a promissory note that obligates him or her to make a series of payments over time. Self-canceling installment notes can provide you with a lifetime income stream and help you avoid gift and estate taxes. In the event of your death, remaining payments on a self-canceling installment note will be canceled.
Private annuity. This allows a buyer to purchase the property in exchange for a promise to make payments to you for the rest of your lifetime. Under a private annuity agreement, you transfer complete ownership of your business to family members or another buyer. Since a private annuity is considered a sale, rather than a gift, it allows you to lessen the value of your estate without incurring gift or estate taxes. However, the buyer may be subject to capital gains tax.
Sale-leaseback. This type of financing allows you to raise cash by selling real estate or equipment your business owns to a buyer for fair market value, then lease it back long-term while continuing to occupy or use it. This can increase cash reserves, which can then be used to fund the purchase under the buy-sell agreement. The advantage of a sale-leaseback is that you get the cash upfront. However, these types of agreements are not guaranteed and you may still fall short of funds needed to finance the buyout.
Appreciated property bailout. Under this type of funding, you exchange company stock in exchange for company assets. These assets can then be sold for cash in the future. There is no guarantee, however, of how much cash you will gain from the future transaction.
Deferred compensation. You, as the business owner, agree to put off receiving a portion of your salary until retirement. That money can be used to finance a buy-sell agreement in the future. However, if the business fails or experiences financial difficulties, it can affect the payoff amount.
Disability insurance. If you or a business partner becomes disabled, the disability policy will pay out a lump sum or installments that can be used to fund the purchase under the buy-sell agreement.
First Commonwealth Bank and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.