R—Key Person Buy-Out Agreement

The key person buy-out agreement is one means of providing for the complete disposition of a business interest. Under this arrangement the owner agrees to sell all of his or her business interest to a key person.

DURING LIFETIME.To illustrate how this works, assume that we have a corporation owned by A. A would enter into an agreement providing for the sale to B, a key person in the business. Typically, this agreement isbindingand obligates both parties, or their representatives, upon the death, disability, or retirement of A.

Rather than trying to accumulate or borrow sufficient funds to buy A’s interest, B obtains a life insurance contract insuring A. B applies for this coverage, pays the premiums, and is both owner and beneficiary of the contract. By this means, B can use life insurance tofullyfund his or her obligation to A.

UPON DEATH.Assuming that A dies first, his or her stock would then pass to his or her family or estate. At the same time, the insurance company pays a death benefit to B, as beneficiary of the contract insuring A’s life. B receives these funds free of all income taxes, since they are received as the death benefit of a life insurance contract.

Pursuant to the agreement, A’s family, or estate, transfers A’s stock interest in the business to B, in return for which B pays the cash received from the insurance company.

The fully funded agreement willassurethat A’s surviving family receives a fair price for his or her interest in the business. But such an agreement can also serve another very important function. If the estate had been subject to estate taxes, it is possible that extensive negotiations and even litigation could result if the estate tax value of the business had been left to chance. These problems of delay and litigation can be avoided by having an agreement that helps establish, or “peg,” the value of the stock.