By Diann L. Andrews
Greg and Brett, both in their mid-forties, had just celebrated the 10th anniversary of Dairy R Us, Inc. Next morning, Brett suffered a heart attack walking out to the barn and died later that day. Greg lost his long-time business associate. And, he had a new co-owner — Brett's wife.
The result was chaos. Brett's wife had little interest or experience in running the farm. She needed cash for living expenses and asked Greg to buy out her interest.
Since most of his assets were tied up in the business, Greg was short of cash. The two were left with little choice but to sell the operation on short notice for a fraction of what they’d hoped for.
This fictional disaster is avoidable. A buy-sell agreement plus proper funding could prevent such a scenario and provide necessary income Brett's family. Buy-sell agreements lay out how ownership will change hands and how the transfer will be paid for in case of a co-owner's death, disability or retirement.
Typically, the agreement provides for the purchase of the departing owner’s share by surviving owners or the company itself. It may achieve several goals:
• Avoid farm liquidation
• Facilitate its orderly continuation
• Replace lost farm income for a deceased owner's heirs
• Set a purchase price fixing the estate tax value of the decedent's ownership share
• Provide evidence of the farm’s financial stability
Drafting a buy-sell agreement will have limited practical benefit unless the purchaser can afford to buy the deceased owner's share. Life insurance is often the preferred cash source. Policy proceeds are used to buy the shares from the deceased owner's estate at a price set in the agreement. Otherwise, farm cash flow must be used, leaving a big hole in the operation’s finances.
Two buy-sell options to weigh
Life insurance can fund both "cross-purchase" and "stock redemption" agreements. Here’s how Dairy R Us would have been affected by each:
• Cross-purchase. In Greg and Brett's situation, each person purchases and is the owner and beneficiary of a life insurance policy on the other. Upon Brett's death, Greg receives the policy's death benefit that he uses to purchase Brett's ownership from Brett's estate. In turn, that cash payment gives Brett's family necessary income to offset loss of Brett's earnings.
Cross-purchase plans have key advantages. The surviving owner gets a "step up" in the income tax basis for the share bought from the deceased's estate. This could reduce income taxes if the surviving owner later sells the stock. And, insurance proceeds aren’t subject to claims of company creditors.
One drawback: These plans can be hard to administer if there are many owners. Remember, owners individually own policies on the lives of their fellow owners. Absent other planning, 56 separate policies would be needed if, for instance, there were eight owners.
• Stock redemption. In this case, Dairy R Us Inc. buys and owns life insurance policies on Greg and Brett. When Brett dies, the company buys his stock with the insurance proceeds.
Stock redemption plans may make sense when there are multiple owners, there are large differences in age and ownership levels among them, or the company is in a lower tax bracket than the owners. Potential drawback: The surviving owners don’t benefit from an increased income tax basis of their shares when the company redeems the stock.
Keep a proper balance
In efforts to make things fair, business owners often structure a life insurance funded buy-sell agreement so all owners are treated alike. That may seemingly result in a windfall if a minority-share holder outlives the majority owner.
Suppose, for instance, the $1-million Dairy R Us Inc. was owned 70% by Brett and 30% by Greg. Under their agreement, each was required to buy the other's stock under identical terms. Each also bought life insurance on the other's life to fund this buyout.
When Brett dies, Greg collects $700,000 of insurance proceeds and pays that sum to Brett's family for controlling interest. Greg is also likely to buy back his own insurance coverage of $300,000 for full value.
Result: Greg, the minority partner, now has a 100% interest in a $1-million company plus a $300,000 policy. Brett's family loses control of the firm, but receives $700,000 in cash plus the proceeds from the sale of the insurance on Greg’s life.
Buy-sell agreements may help protect your farm and family. But always seek the guidance of a professional financial adviser who can identify various issues that’ll help determine what type makes the most sense.
Andrews is a registered Lincoln Financial Advisors investment advisor at Amherst, N.Y.