What would happen to your business if your business partner dies? Buy-sell agreements cover what happens to the business in the event of the death of one of the business owners. A number of business owners in Johnson City, Tennessee have asked me about buy-sell agreements, so I wanted to take some time to explain exactly what they are.
A buy-sell agreement is a life insurance policy for the continuation of your business. It is an agreement you have with other shareholders or your business partner where you either set a time where they will buy your business, or you agree that they will buy it upon your death. In general, most spouses do not want to own your business. Further, most shareholders and partners do not want the spouse to be their new partner. The spouse would rather have the cash, and your business partner or shareholder would rather have the business.
How Do They Work?
To understand buy-sell agreements better, let’s look at a few scenarios.
In the first scenario, we have business owner A, business owner B, and the business where each owner owns half the business. Each business owner has a life policy on the other. It is important to note that you must pay this life policy with after-tax dollars. The business owners would pay, for example, one thousand dollars per year extra (resulting in some small tax consequences). The owner would write a check out of his own checking account so that the proceeds are tax free back to him. This means that you should never write this off as a business expense on your taxes, but rather view it as a personal expense.
Let’s say Owner A passes away. Owner B receives money from the life insurance policy he or she purchased on the life of Owner A. Owner B will pay Owner A’s family for the ownership. If it is a $500,000 policy, Owner B will pay $500,000 to Owner A’s family. The family will face some tax consequences, which they should talk to their CPA about, but Owner B is getting the whole $500,000 tax free. Now Owner B owns 100% of the business. If Owner B were to sell the business, he would sell it with a step-up basis. This means that he pays $0 in taxes on the increase in cost he now has in the business (again, check with your CPA on this).
The situation is a little different when you have 3 owners (Owners A, B, and C). Each owner owns a third of the business and a third of the stock. The business also has treasury stock. Each business owner would have a life insurance policy on them which the business would pay. This is not tax deductible. Let’s say Owner C passes away. The business would get the life insurance proceeds tax free because the policy was paid for with after-tax dollars. The business then pays Owner C’s family the money they received from the policy. Owner C’s stock is then “sold” back to the business by his or her family so that each owner has 50% of the outstanding issued stock, and thereby owns 50% of the business. Keep in mind, the remaining owners do not receive step-up value from the agreement.
In summary, you should always pay the premium with after-tax dollars – never write it off on your taxes. That way, you can receive the proceeds tax free. Also, you should carefully consider the benefits of step-up value when setting up these policies.
If you have any more questions amount buy-sell agreements, or other questions regarding your business or personal/family insurance, contact our Tri-Cities insurance office today at (423) 292-4142. You can also email us at firstname.lastname@example.org. Voted Johnson City’s best insurance, we will be glad to help you make sure you have the coverage you need.