buy-sell agreement Archives - Randel Law, Inc., Your Business and Succession Planning Lawyer as well as Corporate Transparency Compliance

Buy-Sell Agreements Funded by Life Insurance

October 31, 2024 By Rick Randel

Rick Randel Mergers and Acquisitions and Succession Plans for Financial Advisers, File Beneficial Ownership Information Reports with FinCEN under the Corporate Transparency Act

You may have seen or heard references to a recent United States Supreme Court case called Connelly v. United States. I’ve seen blurbs implying that the case invalidates buy-sell agreements or life insurance funding of buy-sell agreements.

Nothing could be further from the truth. All the court said is that the value of life insurance proceeds is counted toward valuing the company for estate tax purposes, and the company’s obligation to purchase those shares is not an offsetting liability. A significant decision by all means, but not one that invalidates life insurance funding.

A brief explanation:

When a person dies, if their estate is worth over $13,610,000, it’s subject to a 40% estate tax. If the deceased owned stock in a company, the value of that stock is counted toward the value of the estate. The more the company is worth, the more the stock is worth.

What the Supreme Court said in Connelly is that if the company held life insurance on the deceased, the proceeds of the life insurance are counted toward the value of the company, but the company’s obligation to buy the person’s shares is not counted as an offsetting liability.

So buy-sell agreements are still valid, and life insurance to fund buy-sell agreements is still valid. The issue is that in some situations, a buy-sell agreement funded by life insurance could trigger or increase the amount of estate tax that is paid.

Connelly only applies to cases where the estate of a deceased shareholder is so large as to trigger the estate tax. From now through 12/31/25, that amount is $13,610,000. Even though that amount will probably go down after 12/31/25, Connelly will still only apply to a small subset of buy-sell agreements.

Also, Connelly only applies where the company is obligated to purchase the shares (sometimes called a “redemption”). It does not apply where the other shareholder(s) are required to buy the shares (a “cross-purchase”). In that case it’s the shareholders who take out insurance on each other, so the insurance proceeds are not counted as an asset of the company in determining the value of the shares.

Therefore, high net worth business owners whose buy-sell agreement calls for the company to buy the shares should consult with their tax and estate planning advisors about switching to a cross-purchase arrangement where the other shareholders buy the shares. Let me know if you need an introduction or would like my help in working with your other advisors to design a solution.

Thanks,

Rick Randel

This post is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.

Can You “Trust” Your Buy-Sell Agreement?

September 14, 2019 By Rick Randel

As many of you know, buy-sell agreements restrict ownership to a small group of owners who know each other and have decided they can do business together. They allow the other owners to buy the shares of an owner who experiences a “triggering event” such as death or divorce.

As many of you also know, many business owners put their shares into their revocable living trust. Which raises the question, what happens upon a triggering event to an owner whose shares are held in a trust?

The typical buy-sell agreement fails to address this situation. I have long suspected the other owners may find themselves unable to buy him or her out.

A recent court decision confirmed my suspicion. A partner whose shares were held in a trust died. The other partners invoked their buy-out rights, but the successor trustee refused to sell. The other partners sued. The court held that the actual partner was the trust, not the trustee. Therefore, even though the individual had died, the partner itself (the trust) didn’t die, and the buy-out rights of the other partners were not triggered. The successor trustee was allowed to continue owning the deceased partner’s shares, despite the other partners’ desire to buy him out. (Han v. Hallberg, 35 Cal.App.5th 621 (2019))

While Han v. Hallberg dealt with a partnership and not an LLC or corporation, a court would likely reach the same result in the corporate or LLC context. The vast majority of buy-sell agreements I have seen do not address what happens when shares or membership interests are held in a trust. A good buy-sell agreement should say that for the purpose of triggering events, the term “shareholder” (or member or partner) refers to the person who is the true underlying owner of the shares, i.e. the person who is active in the business and who the other owners consider to be their “partner”, even if the shares are held in a trust. So a triggering event that happens to that actual person triggers the others’ buy-out rights.

Feel free to contact me if you would like me to take a look at your own or a client’s buy-sell agreement and see if it adequately addresses what happens when shares are held in a trust. If it doesn’t, adding that coverage is a simple fix.

This article is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.

Building Liquidity into Your Buy-Sell Agreement

May 4, 2014 By Rick Randel

In a previous issue we met “Chuck,” a successful business owner looking to monetize his investment in his business. The liquidity tool that Chuck and his advisors ultimately chose was the Ownership Transition Plan (click here to read that issue). Now I would like to introduce you to “Carol” and “Ahmed,” who were also looking for liquidity, but farther in the future. Carol and Ahmed were younger than Chuck and didn’t have any current candidates for ownership. But they were wise enough to plan ahead before their liquidity needs arose. After considering the various owner liquidity tools, we decided to build liquidity into their buy-sell agreement, There are many ways to build liquidity into your buy-sell, including:

Mandatory repurchase upon death or disability
Repurchase upon reaching certain age
Repurchase upon retirement
“Put” right

If you have attended one of my seminars, you have heard me speak about the “two universes” of buy-sell agreements. In one universe (typically small start-ups with little built-up value and young founders), the buy-sell is purely a tool for restricting transfers of shares so the owners don’t wind up partners with someone they don’t know or can’t work with.

Mandatory Repurchase upon Death or Disability

In universe two, in addition to restricting transfers, the buy-sell sets up mechanisms to take care of the owner’s family should the owner die or become disabled. This universe usually involves mature businesses with significant value, the owners of which have families they want to provide for. Either the company or the other shareholders must purchase a co-owner’s shares upon death or disability. The company or the other shareholders often take out life or disability insurance on the other owners to fund their obligation to repurchase shares. This is an excellent means of providing liquidity for an owner’s spouse or children, should his or her income suddenly go away. It is particularly appropriate where neither the spouse nor the children are involved in the business.

Repurchase upon Reaching Certain Age

The buy-sell also can provide liquidity to owners by including mandatory repurchases of shares upon reaching certain ages. For example, any owner who reaches the age of 65 may sell up to 20% of his or her shares per year for the next 5 years. The company is required to make the purchase. The owners can decide what age triggers the requirement and what percentage of shares is purchased each year. The agreement should allow them the flexibility to waive the provisions or negotiate variations for each individual owner, as circumstances dictate.

Repurchase upon Retirement

The buy-sell agreement can also require the company to repurchase an owner’s shares upon retirement. Some owners have no problem with their partners continuing to own an interest in the business after retiring. Others (particularly in service businesses) feel like once someone stops contributing to the business, they should no longer own shares.

In all of the above cases, the company typically has the option to pay a certain percentage of the purchase price (typically 20 or 25%) in cash, and the remainder over several years (with interest), thereby providing a nice income stream to the departing owner. If the purchasing party receives insurance proceeds, however, they must remit all of the proceeds to the selling party. The agreement often imposes an annual “cap” on the amount the company must pay (typically a percentage of revenue or net income), to avoid straining its cash flow. Payments that cannot be made because of the cap are deferred.

Put Right

In rare cases, the buy-sell agreement can even provide for a “put” right, where any owner can require the company or the other owners to buy him or her out at any time. The repurchase price would be determined by a formula set forth in the agreement. This is much less common than the above options, primarily because co-owners don’t want the company to have to buy out another co-owner for no reason other than the owner wants out.

Carol and Ahmed decided to include all of the above tools in their buy-sell, other than the put right. Their company is required to buy their shares upon retirement, or when either of them reaches age 67 (at 20% per year over 5 years). They also included mandatory repurchase upon death or disability, and had the company take out life insurance to fund the repurchase upon death (they decided disability insurance was too costly). In the end, they wound up with a buy-sell agreement that builds in numerous tools for owner liquidity when needed.

If your buy-sell agreement (you do have a buy-sell, don’t you?) doesn’t provide you with liquidity, perhaps it’s time to have it revamped. Even if you feel your buy-sell is up to snuff, remember to have its terms (and the amount of insurance covering purchase obligations) reviewed every few years to make sure it is keeping up with changes in ownership, the value of the business, and the ages and family situations of the owners. The Randel Law Office would be happy to help you with this process.