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08 Oct Funding Buy-Sell Agreements

When it comes time to sell whole or part of your business based on the requirements of a buy-sell agreement, there are a few basic funding and financing options for alleviating the burden required to buy shares from a departing or deceased owner. Each options for selling a business discussed below can get fairly hairy as taxes, business structure and legal issues become involved. The best options is to discuss opportunities based on the recommendations of an M&A advisor.

Installment Purchase

An installment purchase is the most risky options, especially if you’re looking at the sale of the business from the perspective of the departing shareholder. In the installment purchase option either the company, the remaining shareholders or some combination of the two become debtors to the departing shareholder or his/her estate.

In the most simple description, the buyout is done as a redemption wherein the departing shareholder is has his/her stock purchased in exchange for up-front cash, recurring cash payments, a promissory note or some combination of all three. There are a number of nuances incident to the installment purchase for buying out an owner, but this option is not the most ideal.

Death Benefit Insurance

Funding buyouts with insurance is a great option for fulfilling buy-sell agreement mandates. Life and disability insurance can both be used to help fund buyouts. Life and disability insurance is often used in conjunction with other methods to help fund buyouts over time, especially when the triggering event is something other than death of an owner.

Insurance can help provide a perk for a corporate employee, it can protect the interests of the corporation and can be an effective tool for funding the buyout of a departing owner in the business.

The transaction itself can either be funded as a redemption or cross-purchase. The decision of structure is dependent on the number of shareholders, the transfer-for-value and who bears the economic burden of the insurance premiums. Cross-purchase vs. redemption structures of insurance can get a bit hairy, especially as you include tax and business structure variables to the equation.

Much of the motivation behind the business structure for a buyout scenarios will be based on the financial burdens of the insurance premiums and the applicable tax liabilities any structuring could incur.

Cash Policy Loans from Life Insurance

Using a cash policy loan from life insurance is a great option as it can provide needed liquidity at the time of retirement of a shareholder. In most life insurance buy-outs, the trigger event is the death of an owner. With cash value loans from a policy, the company is able to fund payments to an owner prior to his/her death. Premiums, of necessity, are funded with after-tax dollars, but the income build-up on the accumulation in the account is tax deferred.

Split-Dollar Insurance Funding

Split-dollar insurance funding for a buyout is generally a way to provide a perk to the executive owner and its sole objective is not just to fund the buyout. Hence, the split-dollar reference. With split-dollar insurance funding, the company pays a portion of the life insurance premiums equal to the yearly increase in the cash surrender value of the policy. At the time of death, the company will actually receive a portion of the proceeds of the life insurance payout equal to the amount of premiums paid by the company or the cash surrender value at the time of death.

The reason this form of payout is called split-dollar is that it is not used as the sole method for funding a buyout. Other methods are also included, especially if the insurance policy is not fully paid. This is often done in the form of an installment note with interest payable over a specified period.

Earnings Accumulation

Earnings accumulations is a bit self-explanatory. In short, the company simply accumulates earnings as a way to fund the retirement or death of a particular key stakeholder. This option is often the worst and last resort for a company needing to fulfill a buy-sell agreement.

First, accumulated earnings may not be enough in the event of death. Second, most businesses would prefer to use limited cash for funding of operations and corporate growth, not accumulated earnings (also referred to in this instance as corporate “savings”). If earnings are accumulated, there will be pressure to either distribute them in the form of dividends or reinvest them to help growth the company. Thirdly, C-corporations, unless they are converted to S-corps, will often incur a tax on the excess earnings accumulated within the business. There is often a cap on the amount C-corporations are allowed to accumulate within the business without incurring an accumulated earnings tax.

ESOP Funding

While an employee stock ownership plan is not the ideal way to perform a buy-out for most organizations, there is a small niche for which it can work rather well. In an ESOP the buyout is funded by a ESOP qualified retirement plan. Similar to the accumulation of earnings, the ESOP allows for accumulation of funds on a tax deductible basis along with tax deferrals on any earnings from the fund itself.

Many ESOPs can accumulate substantial funds over time, giving sufficient liquidity for the purpose of a buyout under the buy-sell agreement. If insufficient funds are accumulated, there are a number of options available including borrowing against future ESOP fund contributions, almost like a promissory note. Certain capital gains tax nuances are inherent in ESOPs, which can vary greatly depending on whether the buyout was the result of death or retirement.

Problems with ESOPs include a high cost to maintain and administer as well as potential voting control issues when the owner transfers his/her shares. If circumstances are right to make an ESOP a viable option, it can be a great way of divesting ownership under the buy-sell agreement.

Supplemental Executive Retirement Plan

The Supplemental Executive Retirement Plan or SERP isn’t an effective funding option per-se, but does represent an effective method for converting part of the payments for buyout as tax-deductible payments. In effect, it’s a simple contract in which the company is under obligation to pay the owner in the future a specified amount as a SERP.

As a non-qualified retirement plan, it is not a funding option, but a way to avoid tax in the event of ownership divestment. The SERP is structured as an accrued liability on the books of the company and requires a third-party 409A valuation on the company’s stock. Payments made under a SERP are tax deductible to the company and are taxed as ordinary income to the departing owner or entrepreneur. While the owner waives the lower capital gains rates through a SERP, the net tax savings from both the company and the departing owner are generally lower, often allowing for the SERP to make up the different in tax for the departing owner by simply increasing the SERP payouts.

Keep in mind, this is not legal, tax, accounting or investment advice. Please consult a competent professional if you’re intent on making a business decision. 

  • Is your team providing legal advise or other services in this regard?

    • Nate Nead

      We do not. We partner on these matters, but they remain an important piece of higher-level goal for many business owners, hence the thought a few insights needed to be shared. Thanks for visiting!

  • Michael Mort

    Nice summary of a complex matter. In my law practice, the biggest need I see for funding an immediate payout under a buy-sell agreement is when one partner (or group) puts up the money to get the venture going, and the other partner (or other group) provides all the intellectual capital and labor. The investor(s) have a higher risk losing everything on the death/disability of the idea people than is present in other scenarios. I like to say that key man insurance is the key there. In most other scenarios, an installment purchase of decedent’s shares makes sense, because all the partners–and their heirs–share risk and reward pretty much equally.

    • Nate Nead

      Thank you for being sharing specific, real-world examples. These matters can be extremely complex and require the insight of knowledgeable insurance, legal, tax and accounting professionals to be sure no proverbial rock is left un-turned. Thanks again Michael.

  • Les Simpson

    There is now a alternative to installment purchase that eliminates the risk, mentioned above, of the buyer not making the payments. Our attorneys have a 20 yr old strategy that is a hybrid of a 1031 real estate exchange and a installment sale. Representing either the buyer or seller of the business when the transaction is being avoided because of high taxes on sale. The seller sells the asset into a special business trust and the buyer buys it out, leaving cash. The proprietary of the trust prevents any tax being paid. We manage the money for the seller’s retirement and the buyer is in full possession and ownership of the asset. Our attorneys work with the top attorney firms clients in the US on a relationship basis. We have over 2000 clients and the IRS has audited the process over 13 time with no challenges. So if you have highly appreciated assets and the taxes due by the seller is slowing down or stopping the transaction, our attorneys can help. Les@dtaxbenefits.com

    • Nate Nead

      Thank you for sharing Les. Good to showcase time-tested alternative options. Yours is one I failed to include but which (thanks to your presentation) I have some familiarity. Thank you for joining the dialogue and offering useful insight.

  • Some thoughts! Certainly an interesting ‘historical’ perspective on funding buy-outs particularly with respect to insurance/investment vehicles. One comment on ‘accumulated earnings’ is that retained earnings do not automatically equate with available cash (distribute them in the form of dividends or reinvest them to help grow the company). Accountants annually charge depreciation that spreads the cost, effectively against retained earnings, of the asset over its useful life. The entity still needs to set cash aside for asset replacement. Much press recently has been given to entities that have significant cash reserves that in the short-run could be ripe for funding buy-outs.

    • Nate Nead

      Thank you Peter. Don’t we all wish Retained Earnings = Available Cash 🙂

      Yes, the world is awash in capital seeking a good home. It’s part of the Capitalist’s Dilemma: https://hbr.org/2014/06/the-capitalists-dilemma

  • Karl Sorton

    I frequently help business owners with buy sell agreements utilizing life insurance. An estimate of the valuation of the business is needed and each owner is insured his or her proportionate share. During the startup and growth phase a cross purchase plan is typically the easiest and most cost effective to set up. As the business grows and prospers a stock redemption plan may make more sense. These are frequently funded with term life insurance which can be quoted at http://www.pacificinsurancebrokerage.com. Owners planning a buyout may want to use a cash value type of plan to allow the business to accumulate tax deferred dollars to fund a buyout. There are many tax ramifications to consider when setting up a buy/sell agreement which should be discussed with a competent advisor.