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january 2016
How Can a Buy-Sell
Agreement Help a
Business Owner?
Summary table of contentS
Buy-sell agreements are one of the most efficient means 2 What is a buy-sell agreement?
of transferring your business interest. They are primarily 2 What are my options to fund
used to make sure that there is a smooth continuation of a buy-sell agreement?
a business after a potentially disruptive event, such as 3 How does a buy-sell agreement that
is funded with life insurance work?
an owner’s retirement, incapacity or death. A buy-sell 4 How do I make sure the agreement
agreement is a valuable planning tool that can provide meets the needs of the business
for the orderly succession of a family business. Proper and the owners?
funding of the agreement can provide liquidity when
it is most needed — during disability, retirement or at
death. Further, a buy-sell agreement can establish the
purchase price of an owner’s business interest, avoiding
potentially expensive and time consuming delays due
to disagreements over value and possibly helping to
establish a value for estate tax purposes at death.
HOW CAN A BUY-SELL AGREEMENT HELP A BUSINESS OWNER
Understanding
Buy-Sell Agreements
Q. What is a buy-sell agreement? an owner’s retirement, he or she will of the buy-sell agreement. Without
A. This type of legal document is sometimes be receiving the agreed-upon value in a funding plan in place, the buyer(s)
referred to as a business continuation plan, exchange for the business interests, which may be forced to sell assets, take out
a stock purchase agreement, a buyout can be used for retirement liquidity needs. loans or even file for bankruptcy. There
agreement or a buy-sell agreement. It is a Because funding for buy-sell are several ways to fund a buy-sell
legally binding contract that establishes agreements is typically arranged when agreement and several factors that may
under what conditions, to whom and the buy-sell agreement is executed, influence the choice of the funding
at what price an owner, partner or both the placement of additional method. Funding methods include:
shareholder can or must sell his or her financial strain on the business and Cash
•
interest in a business as well as identifying the possibility that funds would not Borrowing
•
who or what is obligated to purchase be available when needed are reduced, Installment sale
•
those interests. ensuring the owner receives a set price Self-canceling installment note
•
resulting in liquidity for the owner or Sale leaseback
•
Q. Why would I want to the owner’s estate. Deferred compensation
•
establish such an agreement? Life insurance
•
A. A typical buy-sell agreement allows Q. What events trigger a buy-sell? Disability insurance
•
A.
the business entity itself or other business A buy-sell agreement must clearly
owners the opportunity to purchase a identify the potential buyers, any Factors that generally influence the
departing owner’s business interest at restrictions and limitations, and the choice of the funding method include:
a predetermined price or pursuant to conditions under which a sale will occur.
a determined formula. This allows the Sale triggering events may include: business structure; size and tax bracket
business and the remaining owners to Death
•
protect themselves from future adverse Disability number of owners and their age, tax
•
consequences, such as disruption of Retirement bracket and ownership percentages
•
operations, entity dissolution or business Divorce
•
liquidation, that might result if certain Voluntary or involuntary transfer levels of cash or credit available
•
events, such as an owner’s sudden of interest in the business to the business or the owners
incapacity or death, should occur. This can Criminal conviction
•
also reduce the possibility that the business Loss of professional license type of buy-sell agreement
•
will fall into the hands of outsiders. Resignation or termination
•
The ability to fix the purchase price of a of employment
business interest makes this tool especially
useful in estate planning. Agreeing to a Q. What are my options to
purchase price while all parties are alive fund a buy-sell agreement?
reduces the possibility of unfair treatment A. For a buy-sell agreement to be
to a deceased owner’s family members. successful, the parties should arrange
It can also provide certainty that upon for proper funding to carry out the terms
2 morgan stanley | 2016
HOW CAN A BUY-SELL AGREEMENT HELP A BUSINESS OWNER
objectively lays out under what
conditions the disabled owner must exit
the business and accept his or her share
of the business interest, thus preventing
a situation in which the disabled owner
“hangs on” even though he or she can’t
handle former duties.
Q. Are there advantages
Life Insurance for my beneficiaries?
A. A buy-sell agreement funded with life
insurance can safeguard the interests of
Funding your beneficiaries in the event of your
death. For example, it can:
Help protect your investment:
•
Your business interest is disposed of
Insurance is generally the most cost- and your successors when you transfer per the terms of the agreement. For
efficient way to fund a buy-sell agreement. your business ownership including: example, it may be converted into cash,
It is the funding element that makes Immediate liquidity: Permanent or it may be transferred as is to your
•
carrying out the requirements of the life insurance cash values and death beneficiaries.
agreement possible by providing the benefits are readily available to fund Help provide a tax-advantaged
•
necessary funds just when they are business sales whether the sale occurs source of funding: Death benefit
needed. It obligates the money for during the owner’s lifetime, such as in proceeds are generally income tax
the stated purpose, thus assuring it is retirement, or at the owner’s death. free to the policy owner, and the sales
available to implement the terms of Cost efficiency: Life insurance is a proceeds should be received tax free
•
the agreement. cost-efficient vehicle compared to other by the estate since the business assets
funding options. Premiums can be would receive a step-up in basis upon
Q. How does a buy-sell agreement that significantly lower than the cost of a loan. the owner’s death.
is funded with life insurance work? Stability: Life insurance death Help protect your family: Buy-sell
• •
A. After a document that meets the benefit options will guarantee there proceeds can be used for family income
needs of the business owners is drawn will be money paid in the event of the needs and estate settlement costs,
up by a legal professional, life insurance policy owner’s death. If the policy is providing a more immediate benefit.
(and disability buyout insurance, if structured to accumulate cash value,
desired) is purchased on the lives of those values can be used to provide a 1 Assuming a life insurance policy is not a
the business owners. The owner and down payment for a lifetime buyout, Modified Endowment Contract (MEC), access
beneficiary of the insurance coverage with the remainder structured as an to policy cash value through loans is generally
may be an individual, (a so-called cross- installment sale. The owner will receive free from current federal income taxes, and
purchase arrangement), or it may be a predictable income stream in the form withdrawals are taxed only to the extent that
the business itself (an entity-purchase of principal and interest payments that they exceed the policy owner’s basis in the
agreement). Upon the death, disability can be used for additional liquidity policy. Withdrawals or loans from MECs are
2
or retirement of an owner, the buy-sell needs during retirement. subject to federal income tax to the extent
agreement can: In the case of disability buyout of the gain in the policy, and if taken before
Identify the purchaser, price and insurance, additional benefits include age 59 ½, may be subject to an additional 10%
•
payment terms for the sale of the business. the following: tax penalty. Loans and withdrawals from a
Utilize any policy cash values or Reduced financial strain on the life insurance policy will reduce the policy’s
• •
death benefits consistent with the business: Nondisabled owner(s) can cash value and death benefit. A policy lapse
buy-sell agreement.¹ avoid dipping into personal savings or or surrender while loans are outstanding may
business funds through the purchase of a result in the recognition of taxable income.
Q. What are the business advantages disability buyout insurance product that There may be penalties and fees associated
of a buy-sell agreement that is funded will help provide the funding to buy the with the use of loans and withdrawals.
with life insurance? ownership interest of the disabled owner.
2
A. A buy-sell agreement funded with life Prevention of disagreements on All guarantees are based on the claims- paying
•
insurance offers several benefits to you timing of departure: The agreement ability of the issuing insurance company.
morgan stanley | 2016 3
HOW CAN A BUY-SELL AGREEMENT HELP A BUSINESS OWNER
A combination of assets and earnings,
•
often called the excess earnings method.
Future earnings, including discounted
•
Structuring future cash flow or earnings methods.
Business valuation can be complex and
caution is necessary. Determining the fair
Buy-Sell Agreements market value of a business may require an
independent business appraiser. The IRS
can impose harsh penalties for understating
the value of an asset for estate tax purposes.
Q. How do I make sure the Q. How do I determine
agreement meets the needs of the value of the business? Q. If I set up a buy-sell agreement
the business and the owners? A. This is perhaps the most difficult thing to a few years ago, am I good to go?
A. Buy-sell agreements can be structured consider in setting up a buy-sell agreement. A. It is important to periodically review the
to meet the needs of both the business and Establishing the worth of the business is provisions of your agreement. Many buy-sell
the owners, taking into consideration tax essential to making the agreement work. agreements address only death as a triggering
consequences and individual goals. It is not For example, if you are a surviving part- event, but it is important to address issues
necessary that the same buy-sell agreements ner, you want to be fair to the decedent’s such as retirement, bankruptcy, divorce and
apply to all the owners of a business. partners’ beneficiaries, but you wouldn’t disability. You should review your agreement
There are four basic structures for buy- want to pay out more than is necessary for to ensure all contingencies are covered. In
sell agreements, and some combinations are the deceased owner’s share. However, the addition, business valuations may need to
possible. A very brief description of the four deceased owner would have wanted his family be updated from time to time.
basic structures follows: to receive the maximum amount possible
An entity-purchase buy-sell obligates the for his business interest. Of course, neither Q. What should I do if I have questions?
•
A.
business to buy the interests of each depart- party knows the position he or she will be Contact your Morgan Stanley Financial
ing or deceased owner. in, so by setting an objective dollar amount Advisor. At Morgan Stanley, we review carefully
With a cross-purchase buy-sell, each in advance — or b y establishing an objective every aspect of your wealth with the goal of
•
owner agrees to buy a share of a departing procedure for determining the amount — fair helping you manage your lifestyle, control
or deceased owner’s interest. The business is play is assured. your risks and take a strategic approach
not a party to this type of buy-sell agreement. There are many different ways to determine to what you own as well as what you owe.
A unilateral or one-way buy-sell is used the fair market value of an ongoing business. Your Financial Advisor can tap a vast pool
•
when only one owner is selling an interest, Which method is selected should be a care- of knowledgeable professionals, including
and is typically used in sole ownership situ- fully studied, professionally advised process. specialists in family dynamics, estate planning,
ations whereby the owner is arranging to Some methods work better for certain types insurance and liabilities management as
sell the entire business to a family member of businesses. Depending upon the primary well as portfolio analysis, traditional and
or key employee. function of the business, methods of valua- alternative assets, and tax-sensitive investing.
A wait-and-see buy-sell is used when the tion could include the following categories: Our specialists will review information
•
parties are unsure whether the business or The market for businesses of a similar provided by you to help identify the strategies
•
the owners will buy the business interest. nature, including comparable sales, indus- best suited for you and your family. Our
Typically, the business is given the first try rule of thumb, and P/E ratio methods. recommendations are objective, without
option, and if it does not exercise the Historical earnings, including capitaliza- bias toward one product or another, and
•
option, the remaining owners are given tion of earnings or cash flow, debt-paying are designed to work in concert with other
the opportunity. If the remaining owners ability, gross income multipliers and divi- strategies you may already have in place.
do not exercise their option, the business dend-paying ability methods. Your Morgan Stanley Financial Advisor is
is obligated to buy the interest, just as with Business assets, including liquidation committed to helping you prepare for the
•
an entity-purchase buy-sell. value and book value methods. future. We look forward to working with you.
Morgan Stanley Smith Barney LLC offers insurance products in conjunction with its licensed insurance agency affiliates.
Since life insurance and disability income insurance are medically underwritten, you should not cancel your current policy until your new policy is in force.
A change to your current policy may incur charges, fees and costs. A new policy will require a medical exam. Surrender charges may be imposed and the
period of time for which the surrender charges apply may increase with a new policy. You should consult with your own tax advisors regarding your potential
tax liability on surrenders.
Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax
or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for legal matters.
© 2016 Morgan Stanley Smith Barney LLC. Member SIPC. CRC1383181 IN24005 CS 8093827 03/16
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