Business Succession Planning and the Buy-Sell Agreement

A triggering event can be either mandatory or optional.After the triggering events have been determined, the parties must determine whether they wish to provide that occurrence of the event makes purchase mandatory, or merely creates a right or an option to purchase under the buy-sell agreement. Like any other contract, the parties have freedom to negotiate the contract terms in a buy-sell agreement in order to reflect the specific needs of the business. There are three common rights that are negotiated in the context of buy-sell agreements, including (1) mandatory purchase requirements, (2) "call"-type options and (3) "put"-type options.

As the name suggests, if the parties provide for a mandatory purchase, all parties to the agreement will be obligated to complete the sale once the triggering event has occurred.

The agreement can also provide for a call-type option, under which the buyer is given the option to purchase upon the occurrence of the triggering event.In this case, if the buyer exercises the option, the selling owner is required to sell the interests.

Conversely, the agreement can provide for a "put" type option, under which the seller is given the option to sell upon the occurrence of a triggering event, and the buyer will then be required to purchase the interests.

In any of these three situations, the triggering event will be crucial to determining whether the provisions of the buy-sell agreement are activated. The parties must consider the fact that, as in any other option contract, if the rights are structured similarly to put or call options, the party giving the option will be free to exercise the option or not to exercise the option upon occurrence of the triggering event. On the other hand, the party who gave the option is bound to perform once the option is exercised within the terms of the agreement.^[7]

How is a buy-sell agreement funded?

A buy-sell agreement can be funded through the use of the prospective buyer's own funds, accumulated earnings, debt instruments or insurance (either life or disability).  While self-funding is possible, many selling business owners prefer the certainty that is provided through other funding methods. Self-funding presents the possibility that the buyer may be unable to obtain the funds upon the selling owner's death or withdrawal.

As a result, many buy-sell agreements are funded with insurance. The type of insurance that is required will depend upon the triggering events specified in the buy-sell agreement itself. If a right to purchase under the agreement is triggered by the seller's death, the buyer or business may fund the agreement by purchasing life insurance that insures the life of the selling business owner.

Death, however, is not the only type of event that may trigger a buy-sell agreement. If the triggering event is the selling owner's disability or retirement from the business, funding may be provided more effectively through a disability insurance policy or a permanent life insurance policy that provides the potential for tax-free loans during the life of the insured. It is also common to treat an "involuntary transfer" as a triggering event. Essentially, this will become applicable if a creditor of an owner attempts to seize an interest in the business in pursuit of the collection of a debt. This can occur if an actual debt is owed to a third party or if one of the owners is party to a divorce proceeding and the interest in the business is being transferred to a spouse who is not an owner. In the event that an involuntary transfer is a triggering event, insurance will not likely be available to fund the purchase.

If the parties have entered into a cross-purchase agreement, insurance funding is accomplished by the business owners purchasing insurance on the lives of each participating co-owner. The entity itself may also set aside accumulated earnings to fund a buy-sell agreement. In a closely held corporation, however, it might be difficult to set aside adequate funds when the operation of the business could benefit from the use of these funds. Further, in case of a C corporation, accumulated earnings above $250,000 can be subject to the accumulated earnings 15 percent penalty tax.

(Editor's Note: In-depth coverage of this issue can be found at Tax Facts Online, the premier reference on the taxation of insurance, employee benefits, investments, and small business.)