When it comes to closely-held businesses, succession planning is not just a best practice, it’s a necessity. Business owners must have a clear plan in place to handle the exit, death, or disability of any shareholder. Failing to do so can leave a business in turmoil, forcing the remaining shareholders to scramble for liquidity. Without a structured plan, they may have no choice but to rely on cash reserves, take out loans, or even sell company assets to fulfill the obligations triggered by a buy-sell agreement. This can put immense financial strain on the business, potentially leading to its dissolution.
A more effective and financially sound solution is to fund the buy-sell agreement with cash value life insurance. This strategy provides immediate liquidity when needed, preventing operational disruptions and ensuring business continuity.
The recent U.S. Supreme Court ruling in Connelly v. United States has added another layer of clarity to how these arrangements should be structured, reinforcing the importance of proper planning. If you have clients who are shareholders in a closely-held business, now is the time to discuss their buy-sell arrangements and evaluate whether they are structured for long-term success.
Step 1: Ensure a Current Business Valuation
Regardless of whether a buy-sell agreement is in place, the first step in any business succession plan is obtaining a current business valuation. Without an accurate valuation, shareholders cannot determine the appropriate funding amount for their agreement. A valuation helps establish a fair purchase price for shares in the event of an owner’s departure, disability, or death, minimizing disputes and ensuring that all parties are treated equitably.
Business valuations should be updated regularly, particularly if the company has experienced significant growth, changes in leadership, or shifts in industry conditions. An outdated valuation could leave the business underfunded or expose it to unnecessary tax risks. Encourage your clients to work with a qualified business appraiser to establish and maintain an up-to-date valuation.
Step 2: Establish a Buy-Sell Agreement
If a business does not yet have a buy-sell agreement, it’s imperative to create one. A buy-sell agreement dictates how ownership transitions will be handled in the event of a triggering event, such as retirement, disability, or death. Without one, disputes among surviving owners or heirs can arise, leading to costly legal battles and potential business failure.
A well-structured buy-sell agreement can take many forms:
- Cross-Purchase Agreement: Remaining owners buy out the departing shareholder’s interest.
- Entity Redemption Agreement: The business itself purchases the departing shareholder’s interest.
- Hybrid Agreement: Combines elements of both cross-purchase and entity redemption agreements.
- Trust-Based Buy-Sell: A trust is used to facilitate ownership transfer for estate planning purposes.
Advisors should work with business owners and their advisors to determine which structure makes the most sense based on their unique business and tax situation.
Step 3: Implement a Funding Mechanism
A buy-sell agreement is only as effective as its funding mechanism. An unfunded agreement is merely a promise without financial backing. If a triggering event occurs and no funding is in place, the remaining shareholders may struggle to buy out the departing owner’s shares, which could lead to selling off business assets, taking on unsustainable debt, or even shutting down operations entirely.
Life insurance is one of the most efficient and cost-effective ways to fund a buy-sell agreement. It ensures that liquid capital is available exactly when needed, preventing financial strain on the business. Some common structures include:
- Owner-Purchased Policies: Each owner purchases a life insurance policy on the others.
- Business-Owned Policies: The business owns and benefits from the policies, facilitating ownership transfers.
- Irrevocable Life Insurance Trusts (ILITs): Used for estate planning purposes to ensure tax efficiency and asset protection.
Funding a buy-sell agreement with life insurance provides certainty and peace of mind, ensuring that transitions happen smoothly without jeopardizing the business’s financial stability.
Step 4: Review and Adjust Existing Buy-Sell Agreements
Even if a business already has a buy-sell agreement in place, it’s crucial to review it periodically. Changes in business valuation, ownership structure, tax laws, or funding mechanisms may require adjustments to ensure continued effectiveness.
The Connelly v. United States case underscores the importance of structuring these agreements properly. In this case, the Supreme Court ruled “a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.” Therefore, for estate tax purposes, the fair market value of the corporation had to include the value of those life insurance proceeds received without the ability to reduce that valuation by the amount of the redemption obligation. This means that businesses relying on entity redemption agreements could face unexpected tax consequences, potentially leaving heirs with a much larger tax liability than anticipated.
This ruling highlights the need for business owners to carefully coordinate their buy-sell agreements with tax professionals. In some cases, switching from an entity redemption to a cross-purchase agreement may be advisable to avoid unintended estate tax consequences. Additionally, ensuring that life insurance policies are properly structured, whether owned by individuals, the business, or trusts, can make a significant difference in mitigating these risks.
Business owners should review their buy-sell agreements with their financial advisors, attorneys, and tax professionals to ensure they align with current laws and business needs. Adjustments may include:
- Updating life insurance coverage to reflect changes in business valuation.
- Revising ownership structures to accommodate new shareholders.
- Modifying agreement terms to ensure compliance with tax laws and Supreme Court rulings.
Secure Your Business’s Future
A well-structured buy-sell agreement is essential for any closely-held business. It protects owners, their families, and employees by ensuring a smooth transition in times of change. However, the agreement is only as strong as its funding mechanism. By using life insurance to fund buy-sell agreements, businesses can guarantee financial stability and prevent the chaos that often follows an unplanned exit.
If you have clients who own closely-held businesses, now is the time to have these conversations. Encourage them to assess their buy-sell arrangements, obtain a current valuation, establish a funding mechanism, and review their agreements in light of recent legal developments. Proper planning today will safeguard their business for the future.
If you or your clients have questions about how to implement or review a buy-sell agreement, contact us. We specialize in helping business owners structure effective, tax-efficient succession plans that provide security for all stakeholders.
