A lot of business owners in Johnson City, TN have asked me about buy / sell agreements, so I wanted to take some time to explain exactly what they are. Buy / Sell agreements are life insurance policies for the continuation of your business. It is an agreement you have with other shareholders or your business partner where you set a time where they will buy your business, or you agree that they will buy it upon your death. Most spouses don’t want to own the business; most shareholders and partners don’t 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.
In this scenario we have business owner #1, business owner #2, and the business, located in Johnson City, TN, where each owner owns half the business. Each business owner has a life policy on the other. Important to note: you must pay this policy with after tax dollars. The business owners would pay, for example, a thousand dollars a year extra (resulting in some small tax consequences). The owner would write a check out of his own checking account for this policy so that the proceeds are tax free back to him, meaning 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 #1 passes away. Owner #2 receives money from the life insurance policy purchased by owner #2 on the life of owner #1. #2 will pay #1’s family for the ownership. If it is a $500,000 policy, #2 will pay $500,000 to #1’s family. The family will face some tax consequences, which they should talk to their CPA about, but #2 is getting the whole $500,000 tax free. Now owner #2 owns 100% of the business. Now if he sells the business, he sells it with a step-up basis, meaning 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. Each owner owes 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 #3 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 #3’s family the money they received from the policy. #3’s stock is then “sold” back to the business by #3’s 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 any other type of insurance for you, your business, or your family, please don’t hesitate to call us today at (423) 292-4142.
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