Business owners need to know that very few tools for planning are as important as a well-crafted buy-sell agreement. While the majority of business owners are focused on the day-to-day business growth strategies, as well as succession planning, many do not think about what happens when a partner suddenly passes away or becomes disabled, or makes the decision to quit the business. Such situations could result in tension, conflict, financial stress, or even the collapse of a healthy company. Buy-sell agreements provide an outline for dealing with those situations however the plan is only as solid as the money behind it. That’s where life insurance and an expert’s knowledge of CPA become essential.
The buy-sell agreement is a legally binding agreement which outlines the manner in which ownership rights will be transferred when a trigger event occurs. Its sole goal is to safeguard the company and to ensure a smooth transition. Without one, the surviving owners may find themselves in negotiations with family members who are grieving, business operations could be interrupted, and the heirs could receive less, or even demand more than that of the former owner’s shares. CPAs can help avoid these problems by ensuring the agreement is financially sound and tax-efficient. While lawyers handle the legal wordings, CPAs provide the financial structure which allows the agreement to work exactly as designed.
Life insurance is usually the most effective method to finance a buy-sell agreement since it offers immediate, liquid capital at the exact moment that it’s required. A lot of small and mid-sized companies do not have the funds to pay off the interest of a partner suddenly, and borrowing funds at an uneasy time could threaten the stability of the company. Life insurance solves this issue. Death benefits are paid in a short time. The funds don’t need to be repaid, and in most circumstances, the funds are refunded without tax. This allows the owners who survived to buy the shares of the deceased partner at a predetermined price while also offering the family an appropriate amount of compensation, without requiring them to participate in the future business operations of the business.
When CPAs create a buy-sell agreement, the first of their tasks is to decide the manner in which the company is valued. This is important since the life insurance policy must be in line with the ownership interest that is transferred. A CPA might recommend a fixed-value or a formula based on revenue or earnings, or a requirement for periodic independent appraisals. An unsuitable valuation technique could lead to disputes or IRS issues, which is why CPAs make sure the approach is reasonable and enforceable. The valuation determines the amount of life insurance required, how premiums are calculated, and how ownership percentages change following a buyout.
Another step to take for CPA is to aid in determining the kind of buy-sell plan is best suited. In a cross-purchase arrangement, each business owner takes out an insurance policy that covers all other shareholders. If one of them dies the remaining owners make use of the funds to purchase the shares of their deceased partner straight from their estate. This can benefit the owners who survived through a rise in their basis which may help them reduce the future capital gains tax. But, the complexity rises as the number of owners increases because each owner must have the same policy for every other owner. CPAs can help businesses navigate this maze to ensure the proper allocation of premiums is made and that basis adjustments are documented in a timely manner.
In an entity-purchase or a stock-redemption agreement, the company itself purchases the life insurance policies,and uses the proceeds to redeem the deceased owner’s interest. This arrangement is easier to manage as the company has the right to purchase and pay for the policies, but it impacts equity differently. Additionally, the survivors do not get an increase in their basis when they purchase shares on their own. CPAs assist in weighing these choices and ensure that the tax consequences are aligned with the owners’ long-term objectives. Many businesses also have hybrid agreements that permit either the business entity or the owner to make the purchase, based on conditions. In these situations, the guidance of the CPA is essential to ensure that the option you choose to use is funded properly and tax-compliant.
We can help business owners avoid common pitfalls that can weaken buy-sell agreements. The most common mistake is allowing the valuation and the life insurance coverage to become outdated. When a company expands in value, the worth of each stakeholder’s stake grows as well as the failure to adjust the amount of insurance coverage can result in an enormous gap in funding. Another problem that can arise is improper management of these policies which could unintentionally trigger tax-deductible situations or create disagreements when a buyout is started. CPAs regularly examine these arrangements to make sure that the documents for business as well as ownership records and the policy structure is in line. They also make sure that they are accounting for the correct amount of premiums and that the contract does not conflict with the owner’s personal documents regarding estate planning.
Since buy-sell agreements have the legal, tax, financial and insurance considerations, CPAs often serve as the primary liaison between insurance professionals and attorneys. In ensuring that the professionals working on the agreement are using the same appraisal projections for tax and structure of ownership, CPAs help prevent gaps that could be detrimental to the contract. CPAs‘ involvement over the long term also ensures that the agreement grows with the company, adjusting to changing owners, growing value, and changes in tax laws.
In the end, life insurance gives the buy-sell agreement its authority, however the power of a CPA guarantees that the authority is properly managed. With the right planning, a buy-sell agreement that is funded by life insurance could help protect the company from financial turbulence as well as treat families fairly and give peace of mind for all those who are involved. For those who own businesses, it’s one of the best methods to ensure their legacy.
If you need individualized guidance in drafting the buy-sell agreement, or to review your existing plan, contact the Parr & Ibarra CPA firm in Keller, Texas. An intelligent plan now can help avoid conflicts, protect your business that you’ve put your heart into and ensure the financial security of all who is involved.
