One of the most important documents to be considered by a business owner, but one that is most often overlooked is a business continuation agreement (also known as a buy/sell agreement). Without proper planning, there may be no exit strategy available to business owners doing business as a corporation or a limited liability company. Expensive and protracted litigation often ensues with nobody winning but the attorneys.
You can avoid this most unfortunate situation by planning in advance and a business continuation agreement or a buy/sell agreement is often just the solution. In this agreement, which should be executed contemporaneously with the formation of the business (and reviewed periodically), you can designate the so-called "triggering events," including death, disability, or resignation. You can also spell out how the business should be valued and the other terms of the arrangement. Income and estate tax considerations are critical.
In a redemption agreement, a deceased owner's interest is purchased by the business, usually with life insurance proceeds. The life insurance proceeds are paid to the company usually tax free. The deceased owner's business interest will be includible in the deceased owner's estate at fair market value. Fair market value would usually be the price set in the buy/sell agreement. The deceased owner's family will be required to sell the deceased owner's interest back to the business. The sale, however, will be income tax free since, as a result of death, the owner's interest will receive a so-called step up in basis equal to fair market value.
Since the sale price is equal to fair market value, there will be no gain, and thus no taxable event. The deceased owner's family is then able to use the proceeds without paying any income taxes as needed for their family and there will be a complete separation from the business.
The redemption agreement may not be advisable for companies with a high risk since the life insurance proceeds become a general asset of the corporation. Also, there is little or no tax advantage to the remaining owner and, for this reason, a cross-purchase agreement should be considered.
The cross-purchase differs from the redemption agreement in that, upon the death of an owner, the remaining owner, rather than the corporation, will buy the shares from the deceased owner's estate. The remaining owner will be the recipient of the life insurance proceeds, which will be used to pay the deceased owner's estate. The proceeds of life insurance payable to the surviving owner will be income tax free, but the surviving owner will obtain a so-called step up in basis attributable to the shares purchased, equal to the fair market value of the shares since that is the amount the surviving owner paid. There is no tax difference to the estate of the deceased owner where the proceeds will be received income tax free since the fair market value of the shares equals the basis of the shares sold.
If the surviving shareholder sells the business following the death of the deceased shareholder, the surviving shareholder's gain will be reduced by the amount the surviving shareholder paid for the deceased owner's shares. This is not the case if the corporation buys back the shares since the surviving shareholder will not acquire any basis in the shares acquired by the corporation.
Avoid protracted and expensive litigation by planning your exit strategy in advance. For more information and to learn additional advantages, please contact us.
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