What happens to your business when you retire—voluntarily or because of a disability—or die? Have you made any decisions about whether to sell your interest, pass it on to children, transfer it to a co-owner if you have one, or make other arrangements? According to one source, two-thirds of small business owners plan to retire in the next 2 years. Are you about to become a statistic? Do you have a buy-sell agreement?
What is a buy-sell agreement?
A buy-sell agreement is a contract among co-owners of a business to fix the actions that will be taken when one owner leaves the business. There are 2 basic types of buy-sell agreements:
- Redemption-type agreements (also called the entity plan). Here the business buys back the departing owner’s interest, leaving the remaining owner or owners with greater interests. For example, say there are 2 co-owners who each own half of a limited liability company. When one owner dies, assets of the company are used to buy back the deceased owner’s interest, leaving the remaining owner with 100% control. If the business is incorporated, the buy-back is done through a redemption of the deceased owner’s stock.
- Cross-purchase agreements. Here, each remaining owner buys out the departing owner’s interest. Say there are 3 equal co-owners in a corporation. When one owner leaves, the remaining 2 owners buy half of the deceased owner’s stock, leaving each remaining owner with a 50% ownership interest.
There are also hybrid agreements that use elements of each type of basic agreement to accomplish their goals.
How to finance a buy-sell agreement
It’s fine and good to have a contract in place, but who’s going to pay for it…and how? Again, there are options here.
- Company buyouts. As mentioned in connection with redemption-type agreements, the interest of the departing owner is acquired by the business, leaving the remaining owners with greater ownership interests. The company may set aside money for this purpose, meaning it retains earnings specifically for this purpose. Alternatively, the company may pay for the departing owner’s interest through profits over time. If the company buying the interest of a departing owner is incorporated, this is referred to as a stock redemption.
- Life insurance. Usually, insurance is used to buy out a deceased owner’s interest. Recently, the U.S. Supreme Court decided that life insurance proceeds from a policy owned by a corporation and earmarked for a stock redemption when an owner dies increase the value of the corporation, which in turn, increases the deceased owner’s interest that is includible in the deceased owner’s gross estate. Insurance can also be used to pay for a retiring owner. Work with a knowledgeable insurance agent to structure insurance financing for a buyout.
- Installment sales. A departing owner may sell an interest under an installment payment agreement.
Buy-sell alternatives
If you don’t already have a preference about who should take over the business when you retire or die, there are a couple of options you can use…assuming the business is incorporated and you’re willing to let employees gain ownership. Using either option requires long-term foresight and the assistance of a tax professional.
- Employee stock ownership plan (ESOP). This can be used for a corporation (C or S) as a way to buy out the shares of a departing owner. In effect, the plan creates a market in which to sell an owner’s shares. The National Center for Employee Ownership (NCEO) says that as of 2024, there are about 6,500 ESOPs covering over 14.7 million participants. NCEO explains how ESOPs work. Find special guidance for S corporation ESOPs here.
- Employee stock option plans. There are a variety of stock option plans that may be used to transfer some ownership to employees. For example, privately held corporations can make transfers of stock options or restricted stock units (RSUs) (collectively called “qualified equity grants” under Code Section 83(i)). This plan enables employees to defer income resulting from their acquisition. The U.S. Chamber of Commerce has a guide on stock options for small businesses. And the IRS has information about the tax considerations in each type of stock option plan.
Final thought
“Circumstances can force your hand. So think ahead!” ~ Robert A. Heinlein, science fiction writer and aeronautical engineer
Don’t leave the details of your business succession to chance; prepare for things now. Discuss your situation with parties that need to know…co-owners, spouse and children, employees, and others. Work with a knowledgeable attorney who can draft a buy-sell agreement and other necessary documents. Consult with a CPA to be sure you are factoring in tax consequences to your decisions.
