In this article, we will review the benefits of BSA, discuss design and insurance funding strategies, and will identify the types of prospects that can benefit from these valuable succession planning arrangements.

Benefits

A BSA generally provides many important benefits to the owners, successors, and to many others that depend upon the success of the business.

• First, a BSA usually limits the ability of a business owner to transfer his or her business interest. In other words, most BSA require that a business owner offer his or her interest for sale to the business or to its successors before any lifetime sales are made to a third party. Upon death,most agreements provide for the mandatory purchase of a decedent’s business interest.
• Second, a BSA typically creates a prearranged market, price, and payment terms for the sale of a business interest. In light of the limited market potential and the illiquid nature of most business interests, a pre-arranged sale usually provides owners or family members with a better financial outcome than either a forced business sale or liquidation.
• Third, a properly established agreement can usually “peg” the value of a decedent’s interest for Federal Estate Tax purposes. Under IRC 2703, family buy-sell agreements are subject to considerably more scrutiny than transactions entered into between unrelated individuals.
• Fourth, a BSA funded with life insurance can also increase the likelihood of a smooth and harmonious transition. In addition to buy-sell funding, it also makes sense to consider a company’s key person life insurance needs. Upon the death of a business owner or key employee, key person life insurance can be used to “stabilize” a business with “discounted capital” that never needs to be repaid. Key person insurance proceeds can also be used to offset declines in profitability or business values, to hire or recruit replacements, to extinguish debt, to provide capital needed, to fund overhead or expansion, or to fund the income or distribution needs of the surviving business owners.
• Fifth, a BSA can provide security and protection to family members, employees, customers, and to many others that depend upon the success of the business. Although some of these individuals can sometimes be overlooked during planning discussions, many business owners feel a significant sense of responsibility to these important individuals.

Plan Design

One of the most important factors affecting the design and funding of a BSA is the form of doing business. For sole proprietorships, a BSA is usually structured as an asset purchase agreement. Under an asset purchase agreement, the BSA will identify the specific assets that will be sold along with the agreed upon price, payment terms, and conditions that apply to the sale.

If a sole proprietor can identify a prospective purchaser, it usually makes sense to incorporate the business in order to facilitate the continuation and transfer of the business. In other words, it is generally much easier to transfer shares of stock in a corporation or a member’s interest in a limited liability company than to transfer title to specific assets owned by an individual or an estate.

If the business is operated as a partnership or as a corporation, a BSA may be designed as either an entity or individual purchase arrangement. Under an entity arrangement, the entity purchases and owns life insurance

to fund its purchase obligations.

If a BSA is structured as an individual purchase arrangement (e.g. a one-way purchase arrangement or cross-purchase arrangement), an individual (e.g. an employee, other owner, partnership or trust) will purchase coverage to fund the purchase of a business owner’s interest. For example, a one-way BSA might be established to fund a key employee’s purchase of a sole shareholder’s interest or a cross-purchase might be used if there are two or more business owners.

When there are a small number of business owners, a “cross purchase” arrangement

is sometimes viewed as a more attractive alternative than an entity BSA. For example, two share-holders of a regular or “C” corporation might decide to establish a cross purchase plan funded with life insurance to provide the surviving owner with an opportunity to minimize his or her potential capital gains tax exposure if a future sale were to occur during the survivor’s lifetime.

In other cases, cross-purchase arrangements are used to avoid potential dividend treatment to a decedent’s estate that might occur if the family attribution rules of IRC 318 are a concern.

In some situations, cross-purchase plans become impractical if there are several owners since such plans usually require multiple policies absent the creation of a special trust or partnership that is designed to purchase a single policy for each owner.  Although a detailed discussion of these special trusts and partnerships are beyond the scope of this article, these arrangements (and cross-purchase arrangements in general) can potentially create exposure to the transfer-for-value rules of IRC 101.

Weighing Business & Tax Considerations

In a nutshell, the decision as to whether to design a BSA as an entity or individual purchase arrangement usually involves the weighing of many business, tax, and legal considerations. Some of the more important business considerations include the objectives of the owners, the value of the business and its future prospects, business control issues, insurability and premium paying considerations, the number of parties involved, and the likelihood that new owners will join and leave the business over time. In addition, other types of state and Federal laws (e.g. corporate laws, banking regulations etc.) can also sometimes influence the design and funding of certain buy-sell arrangements.

From a tax perspective, the design and funding of a BSA can raise income, capital gains, and estate tax issues that can potentially affect a business and its parties. In other words, the tax consequences to the parties will depend upon the form of doing business and how it is designed (e.g. entity or individual purchase arrangement).

In summary, the design and funding of a BSA often requires the weighing of many businesses, tax, and legal considerations that are not always apparent. Therefore, it always makes sense to consult with a client’s tax and legal advisor before funding a new or existing BSA.

Valuation Issues

One of the most important provisions in any BSA is its valuation provision. Practically speaking, the goal of a business valuation used in a BSA is to develop a fair and reasonable price for the business that will be accepted by the parties and that will be respected by the IRS.

Business valuations are generally developed by using either a formula or by a formal business appraisal. Valuation services can generally be obtained by specialized business appraisal firms or by accounting firms that specialize in business valuation matters.

As a financial advisor, it generally makes sense to develop professional relationships with local business valuation firms to facilitate business and estate planning with your clients. In addition, it is also important to encourage your clients to review their valuations periodically since the value of any business will increase or decrease over time.

Insurance Planning

In general, a BSA can be funded with both disability and life insurance products. As with any insurance sale, insurance recommendations should be based upon a careful analysis of needs, objectives, health issues, and any other personal or business consideration that might be relevant.

A BSA can be funded using either term or permanent life insurance products. For clients with limited cash flow or short-term needs, term insurance is generally the most attractive solution. If cash flow is less of a concern, permanent insurance can be a more attractive alternative when funding long-term coverage needs or to develop cash values for a lifetime buy-out or for any other accumulation need.

Finally, as you fund your business client’s buy-sell and key person needs, it usually makes sense to review the personal insurance needs of the owners, successors, and their families since many individuals are underinsured for their personal, spousal,

and estate planning needs.

Marketing & Advanced Sales Support

The best prospects for buy-sell planning are successful family and non-family businesses. These prospects may be found in almost every industry and profession. In general, your best prospects generate significant revenues and profits, have long term business potential, own significant business assets, and have many employees.

The first brochure entitled “Succession Planning For Family Business” (CLSC5701) reviews the important challenges and opportunities facing family business owners who are seeking to pass a family business on to family members.

The second brochure entitled “Exit Strategies For Business Owners” (CLSC5694) identifies the need for business owners to develop integrated retirement, succession, and estate planning strategies during their lifetime.

As you work with your existing business clients and new prospects, please feel free to call any of our experienced attorneys for sales-oriented case design support.