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| Disability Buy Outs (Con't) By Michael E. Stuneck |
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A properly drawn disability buy-out agreement can address all of these issues. It will define the value
of the business, and will provide the working parties with the mechanism and financial wherewithal to buy
the non-working owner's share of the business. This provides many advantages to the remaining owners: 1. The business interest of the disabled owner may be obtained at an agreed-upon price. 2. A competitor may not buy the disabled owner's shares 3. Insurance can be purchased to provide the funding without creating a sinking fund, or borrowing. For the disabled business owner, there are also advantages: 1. Provides a ready market for his share of the business. 2. Money from the purchase can be used for anything. 3. Spouse and children do not need to become involved to protect themselves. There is more than one way to create the agreement, just as in creating an agreement for the death of a business owner. The most common are "Cross-Purchase" and "Entity Purchase." Depending on the structure of the business, namely, the number of owners, one may be preferable to the other. Other concerns may be cost basis and therefore, taxation at the ultimate sale of the business by the remaining owner(s). The simplest way to structure the plan is called a cross-purchase agreement. If there are two owners, each purchases a policy on the other. They would pay for it out of personal funds. Since they paid for it with after-tax dollars, the benefit would generally be not taxable. Thus if brothers Dave and Ed bought policies, on each other, and Dave was disabled, the benefit would be paid to Ed, who would use the proceeds to buy Dave's share of the business. As such, Ed's cost basis in the business would increase by the amount that he paid to Dave. When there are two or three owners this can be the better way to structure it, due to its simplicity and the appeal of an increase in cost basis. However, it becomes cumbersome when there are several owners, since each owner must purchase a policy on all of the others. The formula for this (where X equals the number of owners) is X times X-1. So, if there are four owners, and each buys a policy on the other three owners, twelve policies are necessary. Cross-Purchase can be also be less appealing if there is a wide range of ages among the owners, or if health issues drive up the premium for the insurance on one of the owners. In this case Entity Purchase could be the answer. In Entity Purchase, the company buys and owns the policies. The company also receives the benefit. So if Dave and Ed had an Entity Purchase plan, and Dave was disabled, the company would receive the insurance benefit, which it would pay out to Dave in return for his share of the business. Ed would be the sole owner, but number of shares, and his cost basis would remain the same. In either case, you should consult your tax advisor before entering such an agreement, as an error could be quite costly. |
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