Cross purchase, stock redemption, wait & see ... oh my! What does all this mean?

• Author: Bannon, Mel B.
• Position: BUSINESS SUCCESSION AGREEMENT BASICS

Ajax Engineering, Inc. was owned equally by Matt and Jeff, both in their mid-forties. Shortly after celebrating the tenth anniversary of the firm, Jeff left for a fall hunting trip with some of his college buddies. He never returned. A tragic accident occurred during the hunt, killing Jeff instantly. Matt suddenly had lost his longtime business partner. What's more, after Jeff's estate was settled, Matt found himself with a new co-owner, Jeff's wife.

Absolute chaos resulted. Jeff's wife had no training or experience in engineering, let alone in running a firm. She was focused on income for living expenses and upcoming college education expenses for her three children. However, Jeff's assets were virtually all tied up in the business and it was the income from his work product and business profits that was providing family lifestyle income. He had few assets outside his business interest and little life insurance. Unfortunately, they were left with little choice but to sell the company on short notice for just a fraction of what it was really worth as a going concern.

Both this business and family tragedy could have been avoided. A buy-sell agreement and proper funding could have saved their business while providing needed income for Jeff's family after his death. 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 shareholder's stock by the surviving shareholders or the company itself.

Properly designing and funding a buy-sell agreement may achieve the following objectives:

* Avoid liquidation of the business

* Replace lost income to a deceased owner's family

* Set a purchase price that fixes the estate tax value of the decedent's stock

* Indicate the continued stability of the firm to customers and creditors

Life Insurance Funding

The first step, of course, is designing and drafting the agreement. However, the agreement in and of itself will have limited practical benefit unless the purchaser can afford to buy the deceased owner's shares. Life insurance is often used as the preferred source of cash. When a business owner dies, the policy proceeds are received tax-free and in turn used to buy the shares from the deceased owner's estate at a price set forth in the agreement. The "cost" of the purchase is not the purchase amount, but the sum of premiums paid, a fraction of...