Sedona Arizona

How do Buy-Sell Agreements Work?

When a business owner passes away, it’s essential to have a plan in place for what happens to their shares. This is where a buy-sell agreement comes in, ensuring a smooth transition of ownership.

But who actually buys the deceased owner’s shares? How is the purchase of the shares funded? The answer depends on the type of buy-sell agreement you have.

Cross-Purchase Agreement

In a cross-purchase agreement, the remaining owners are the ones who buy the deceased owner’s shares:

  • Buyers: The surviving owners.
  • How It Works: Each remaining owner buys a portion of the deceased owner’s interest. This is often funded through life insurance policies that the owners take out on each other.

For instance, if there are three partners and one passes away, the other two will purchase the deceased partner’s shares, ending up with a 50% stake each.

Entity-Purchase (Stock Redemption) Agreement

An entity-purchase agreement, also known as a stock redemption agreement, means the business itself buys the deceased owner’s shares:

  • Buyer: The business entity.
  • How It Works: The business uses funds, often from life insurance policies it holds on the owners, to buy the deceased owner’s shares. These shares are then either retired or redistributed among the remaining partners.

So, using the same example of three partners, if one passes away, the business buys back the shares and either retires them or reallocates them to the remaining partners.

Hybrid (Wait-and-See) Agreement

A hybrid agreement, or wait-and-see agreement, gives you a bit of both worlds, providing flexibility in who buys the shares:

  • Buyers: Could be the business entity, the remaining owners, or both.
  • How It Works: The agreement starts with the business having the first option to buy the shares. If the business passes, the remaining owners get their chance. If neither party buys, the business may be required to purchase the shares.

This type of agreement allows you to adapt based on the situation when the owner’s departure happens.

Choosing the Right Agreement

Deciding between a cross-purchase, entity-purchase, or hybrid agreement depends on your business’s needs and the owners’ preferences. Here are some quick tips:

  • Cross-Purchase Agreement: Great for direct ownership transfer and potential tax benefits, but can be complex if there are many owners.
  • Entity-Purchase Agreement: Easier to manage and keeps transactions within the business, but lacks some tax advantages.
  • Hybrid Agreement: Offers flexibility but needs clear planning to ensure smooth execution.

When setting up a buy-sell agreement, it’s smart to consult with your attorney and financial advisor to make sure it fits your business goals and financial situation. A solid buy-sell agreement not only protects your business but also gives peace of mind to all owners, knowing that the future is secure, no matter what.

Planning for the unexpected doesn’t have to be complicated. With the right business monetization strategy in place you can ensure your business stays strong and steady, even when life throws a curveball. We can help. Contact us today to learn more about our wealth and exit planning services tailored for entrepreneurs and business leaders.

Author: Dale Shafer II, CFP®, APMA®, CDFA®

The National Association of Personal Financial Advisors
The Society of Advice

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