Have you ever seen rodeo cowboys riding bulls?  I marvel at the ride, and marvel even more on how they get off alive!  Running a business can be a lot like that.  When business owners of closely-held businesses are planning for ways to get out of the business someday, we call that Business Succession Planning.

The Buy-Sell agreement is a great Contingency plan, helping set in motion who buys who out at what price, when, and at what terms. 

The question often arises regarding whether it would be best for the business to buy out the widow, retiree, or family, or should the other stockholders buy the stock directly.  Frequently, there is no clear cut answer. In fact, no answer may be appropriate until the death, disability, or retirement of a major stockholder.  Circumstances change dramatically from time to time.  Tax laws are constantly in a state of flux.  What is good today may not be tomorrow.

Because answering this question can be so difficult, sometimes no decision is made (which is also a decision), is the worst decision of all.  The life insurance agents, planners, accountants, and/or attorneys who work with the business owners will bring the subject up again periodically. 

Unfortunately, though, the answer doesn’t get any easier with time.  Whenever the decision can’t be made which method to use in business succession planning, an approach known as a “ Wait and See” buy-sell plan may just fit the bill. Basically this approach assigns options to both parties (stockholders and corporation).

In general it has the 7 following characteristics:

  1. The corporation has the first option to purchase the stockholder’s shares at the time of his or her death, total disability, or retirement.

  2. Assuming the corporation doesn’t exercise its option, a secondary option is granted to each remaining stockholder.

  3. To the extent shares remain unpurchased under the two options described above, then the corporation is required to purchase the balance of the shares.

  4. Each stockholder is required to purchase life insurance on the lives of the other stockholders.  These policies may be paid for with personal dollars, possibly through a Section 162 executive bonus or split dollar life insurance arrangement .

  5. The policies purchased usually provide for increasing death benefits and have cash values calculated to be sufficient to fund an installment sale at the expected retirement date of each stockholder.  There are other designs whereby the cash values are used as substitutes for  warehousing safe funds for business and/or investment purposes, taking the place of low-interest rate bank savings funds.  This concept is usually referred to as the “Infinite Banking Concept”, which follows the ideals in the book written by Nelson Nash entitled "Becoming Your Own Banker".  (Visit www.infinitebanking.org for more information about the book and author.)

  6. The agreement permits stockholders to utilize policy cash values and death benefits to either fund a cross-purchase arrangement  (the stockholders buy each other out directly), or advance funds to the corporation as contributions of capital to be used for a corporate stock redemption, or both.

  7. The agreement also offers an option to purchase individual disability policies to fund a disability installment sale if that is a risk that is of concern.


The many advantages provided by the plan
The advantages to the stockholders, the estate and heirs of deceased stockholders, and the corporation itself are numerous.

  1. The presence of such a plan creates certainty rather than doubt among stockholders.  They know what will happen upon their or any other stockholder’s death, disability, or retirement. The life insurance provides for the funds to honor the agreement.

  2. Step up in Tax Basis:  Since the Death Benefit on the life insurance policy is tax free, all parties will receive a step-up in tax basis, meaning less capital gains taxes to be paid.

  3. If the buyout occurs due to a death, the Death Benefit usually results in the purchase occurring at “pennies on the dollar.”

  4. The plan provides job security to stockholder-employees of the corporation.

  5. The plan allows for each remaining  stockholder to acquire the life insurance policy owned by the deceased stockholder’s estate without introducing a “transfer for value” problem.  In short, the death benefit received on the remaining stockholders would remain tax-free in the hands of the new owners (insured).

  6. Stability:  A plan is looked upon favorably by the banks, suppliers, customers, and employees.

  7. Financial Strength:  If a plan is set up with growing cash values, this will help strengthen the balance sheet of either the corporation and/or stockholders.

  8. Stability for family:  The family won’t have to depend upon the uncertain financial condition of the business at the stockholder’s death.

  9. Defense against the IRS: The plan may help avoid a costly legal battle over business values, when the estate tax return is filed. There are many examples where there were huge discrepancies regarding the agreed upon value of the business when the business did not have a buyout plan in place. The opposite is also true;  there are many examples where the IRS had to acquiesce on their position due to the fact that there was an existing buy-out plan  in place (with defendable formulas and values, pre-agreed, prior to the buy-out event).

  10. The estate and heirs receive the Going Concern Value for the buy-out, rather than the losses that likely would be suffered in a forced liquidation scenario.

  11. Double Duty: With proper design, these same contracts can be used to supplement retirement of each stockholder in a tax-advantaged way (with proper design, tax-free).

  12. Finally, the corporation would benefit since the plan would create a more productive environment  for all stockholders.

For questions and/or comments,  email Patrick R Davidson at pat@providentfinancials.com; or call 208-371-4696.

by Patrick R. Davidson, MBA
Business Consultant and Wealth Coach, Provident Financial Services

Daniels Construction Company

James Daniels formed his company in 1965.  He sensed a great opportunity to get in on the building boom in the Southwest that no doubt would occur.  He started his business on a shoestring, but after only six months he had so much work he began hiring a small crew.

The business continued to grow until his employees totaled 20 by 1975. The business continued to grow steadily through the decades, despite the ups and downs of the economy.  By 2005, the company had 67 full-time employees, including two sons and daughter, Jeff, John and Gina. 

Over the years his children had become owners of nearly 60% of the company’s stock.  After James died in 2007, the balance of the stock was inherited by his children.

Having funded the buy-out with a cross-purchase buy-sell arrangement, Jeff, John and Gina now own 1/3 ownership in a thriving business.  

After their father’s estate had been settled the three children sat down with their attorney and decided to review and revise their business succession plan in case any of them were forced out of the business because of death, disability, or retirement. 

This was particularly important since all three had families at home with children nearing college age.  After several meetings covering nearly six months, with the help of their attorneys, accountants, and life insurance agents, Jeff, John and Gina agreed they needed at least $2.5 million each since the business was valued at just under $7.5 million.

Because of the buy-out at the time of their father’s death, each now had a basis in the business of about $500,000, for a total of $1.5 million. The business has accumulated earnings and profits (surplus) of approximately $6 million.

The company’s comptroller points out that the eventual reduction of the $6 million surplus would be very desirable since its presence could have substantial tax impact if a buy-out were to take place. 

The arrangement proposed takes this fact into account.

The decision is made to adopt a “Wait and See” buy-sell plan, spelling out the Business Valuation formula used, price, and terms or a buy-out of deceased stockholders estate in the event of death, disability or retirement. 

Each sibling will purchase a $1.25 million Equity Indexed Universal Life policy on each of the others.  The “ Wait and See” buy-sell approach provides the opportunity to reduce the surplus if it still exists at the time of death of any of them.  This can be done by the redemption of the stock by the corporation.

Employing this approach, at the first death, the surviving stockholders would contribute $2.5 million to the corporation, which would then use the funds to purchase stock from the deceased stockholder’s estate.  Both surviving stockholders’ basis would be stepped-up by $1.25 million, thus reducing the surplus by twice that amount.

If there is no significant surplus at the time of death, a cross purchase buy-sell may be accomplished instead.  This approach would have the surviving stockholders using the death proceeds to each purchase half their deceased sibling’s stock, thus increasing tax basis by $1.25 million, for each of them.  

The “Wait and See” buy-sell approach provides options that don’t need to be selected until the buy-out is eminent.  In the end, this might be a tool that also will  help “ Get off that wild Bull.”