The death of an owner of a closely held business is typically disruptive for the business and often leads to its failure. When a business owner dies, the executor of his or her estate has the role of collecting, preserving, and distributing the decedent�s assets. Of course, such assets include both the business and personal assets owned by the decedent at the time of his or her death. The closely held business presents many difficulties for the executor unless the decedent�s estate was appropriately planned for business continuation. A properly designed buy-sell agreement will assure that the estate will be able to sell its interest in the closely held business for a reasonable price. The purchasers of the business interest, perhaps the surviving co-owners of the business, will obtain the business interest and avoid the difficulties associated with passing the business interest through probate. Without an appropriate continuation plan, the executor may be compelled to sell the business interest to pay the estate�s settlement costs and federal estate taxes and/or state inheritance taxes. The settlement costs must be paid in cash promptly after the business owner�s death. For example, the federal estate taxes are due 9 months after death. Some state death taxes have earlier deadlines. Under these circumstances, the executor will have a tenuous bargaining position, and a forced sale of the business interest may yield far less than full fair market value. Without a buy-sell agreement therefore the surviving co-owners face a great deal of uncertainty. The survivors may be pressured to provide distributions of business income for the decedent�s heirs. They may also face the prospect that the executor or the heirs may choose to sell the business interest to outsiders. In any event, the failure to plan for business continuation increases the probability that the business will ultimately fail.

Although contemplating death is not pleasant for anyone, proper estate planning employing a buy-sell agreement offers several advantages. The benefits of such an agreement can be summarized as follows:

A properly designed buy-sell agreement has several provisions that will generally be included regardless of the type of agreement. The parties to a buy-sell agreement should be aware that the agreement is an important legal contract that carries out a critical purpose. The parties are advised to obtain competent legal counsel to assist in forming the agreement. Provisions of the typical buy-sell agreement include the following:

The sole proprietorship is by far the most common form of business ownership. It is distinct from other forms of business ownership in many ways. Most important, there is no legal distinction between the business and personal assets of the owner. Only one individual can be the owner of a sole proprietorship. As such, when the sole proprietor dies or loses legal capacity to transact business, the sole proprietorship must terminate. Planning for this contingency is essential if the sole proprietor�s family can expect to get full value for the business interest.

Since there is only one owner of a sole proprietorship, its buy-sell agreement necessarily has a definite buyer and a definite seller. The buy-sell agreement will bind the proprietor�s estate to sell and the purchaser to buy the proprietorship assets. There is no question as to who will be the purchaser and the seller since there is only one owner with a business interest to sell.

A critical step for a proprietorship buy-sell agreement is to find the appropriate purchaser. A natural successor to the sole proprietor may not exist. That is, there are no co-owners of the sole proprietorship waiting to take over. Quite often, the sole proprietor has no family successors who are capable and/or willing to step in at the sole proprietor�s death. Choosing the appropriate buyer requires careful planning. Often a key employee or group of employees will be selected as purchaser. Such individuals, if available, are logical choices for two reasons. First, the key employee or employees of the sole proprietorship are familiar with the business interest. This is particularly important if the business requires unique skills to perform its function. Second, the key employees may be willing to enter into a buy-sell agreement to protect their own future employment. Without a buy-sell agreement, the sole proprietorship will often be liquidated or sold to outsiders at the death of the proprietor. This could leave the key employees unemployed and without a future in the proprietorship.

If there are no key employees or natural successors to the sole proprietor, a careful search will have to be made. It is often recommended that the sole proprietor hire and provide a training program for an employee who has the potential to take over the business. Or the sole proprietor could seek a buyer from competitors who may desire to take over the proprietor�s business at some point in the future. This is particularly appropriate for a professional practitioner who has developed substantial goodwill and a large patient/client list. The death of the sole practitioner will result in the loss of that goodwill unless a purchaser can be found for a buy-sell agreement.

The life insurance arrangements for a sole proprietorship buy-sell agreement are relatively simple. The purchasing party is obligated to provide sale proceeds to the deceased proprietor�s estate. Accordingly, the applicant, owner, and premium payer for such life insurance should be the purchasing party. The purchaser should obtain sufficient coverage on the life of the sole proprietorship to make the required payments to the estate. Insurable interest exists for such a policy since the purchaser has a financial obligation created by the death of the sole proprietor-insured. The insurance funding the agreement should be reviewed periodically, and the purchaser should obtain additional coverage necessitated by an increase in the value of the proprietorship.

A general partnership terminates by operation of law at the death of the partner unless the partnership agreement provides for continuation. Without lifetime planning a deceased partner�s interest in the partnership will have to be liquidated by the surviving partner(s). The surviving partners are required to provide a fair liquidation price to a deceased partner�s estate. However, it is often difficult for the surviving partners to provide these payments without a tremendous burden on the future partnership income.

The goal of the surviving partners is to continue the business of the partnership without interruption. Certainly, they would like to keep liquidation payments to a minimum. Therefore the surviving partners� goals are, obviously, incongruent with those of the deceased partner�s estate. Without a prearranged agreement, a dispute between the heirs and the surviving partners is nearly inevitable. The estate may be compelled to settle for far less than the fair market value of the business. If the surviving partners cannot make the required payments, the partnership may have to be sold or terminated�a result that generally benefits neither the heirs nor the surviving partners. The solution is a binding partnership buy-sell agreement.

A partnership buy-sell agreement is different from that of a sole proprietorship. Since there is more than one owner, the partnership buy-sell agreement must address the possibility that any of the partners will be the next to die. Therefore the partnership buy-sell agreement contains mutual promises between the partners that provide for different purchasers and sellers depending on the circumstances. That is, each partner will bind his or her estate to sell if he or she is the first to die. Each partner will also agree to purchase the partnership interest held by the deceased partner�s estate if he or she is among the surviving partners.

Entity Approach. Under the entity approach, it is the partnership that becomes the purchaser in the buy-sell agreement. Technically, the partnership liquidates the interest held by the deceased partner�s estate. That is, the partnership makes payments to the estate that liquidate the interest the estate holds. Liquidation payments are divided into two components. The first component is a payment in exchange for the decedent�s partnership interest. These payments are subject to capital-gain tax treatment. The remaining payments are ordinary income items that are taxable on the estate�s income tax return, such as the deceased partner�s share of partnership income and unrealized receivables. Under an entity buy-sell agreement both the partners and partnership are parties to the agreement. The partnership agreement provides for continuation of the partnership�s business by the survivors.

Cross-Purchase Approach. In a cross-purchase agreement the individual partners are the sellers and purchasers. The partners each make mutual promises to be a buyer or seller depending on the circumstances. Each partner agrees to purchase a share of any deceased partner�s interest. Each partner also binds his or her estate to sell its partnership interest to the surviving partners. Although the surviving partners purchase the interest from a deceased partner�s estate, the tax treatment of the purchase and sale is similar, but not identical to, the entity approach. That is, some portion of the purchase price will be treated as the exchange of a capital asset�the partnership interest. The remaining portion of the purchase payments will be treated as distributions of income to the deceased partner�s estate.

The choice between the entity or cross-purchase approach is a complex one. Details such as the number of partners, the differences in income tax treatment, the cost basis of the different partners, and the financial considerations of the partnership will dictate the appropriate choice. A partnership should not enter into a buy-sell agreement without careful consideration and planning with respect to the form of the agreement.

Entity (Liquidation) Agreements. The entity buy-sell approach provides that the partnership will liquidate the interest of a deceased partner at his or her death. If life insurance is used to fund the agreement, the partnership is a logical choice for applicant, owner, and beneficiary of the policies. After all, the partnership will have the obligation to pay the deceased partner�s estate. The partnership should acquire life insurance on the life of each partner who becomes a party to the agreement. To the extent possible, the partnership should maintain face amounts of coverage that equal its obligations under the buy-sell agreement.

Generally the partnership should adopt the entity approach if it is in a better financial position to make the premium payments than the individual partners. This will be particularly true if some partners are younger and/or own smaller partnership interests. The partnership ownership of life insurance creates a pooling approach to funding the buy-sell agreement. The business might also adopt the entity approach if there are a large number of partners entering into the agreement. Fewer individual life insurance policies are usually required if the partnership has more than two partners.

Cross-Purchase Agreements. The cross-purchase agreement provides that the surviving partners are obligated to buy a prearranged share of a deceased partner�s interest from his or her estate. The agreement is generally funded by life insurance policies owned by the individual partners. Each partner should purchase life insurance policies on the life of the other partners whose deaths will obligate the policyowner to purchase the decedent�s partnership interest. Thus the individual partners become owners, beneficiaries, and premium payers for life insurance policies covering the lives of the other partners. At the death of a partner, the surviving partners receive the death proceeds from the policies, which will be transferred to the deceased partner�s estate in exchange for the partnership interest. Each partner should secure a policy with a death benefit equal to his or her share of the purchase price of a deceased partner�s interest.

Many closely held enterprises are incorporated by their owners. A corporation is a separate legal entity apart from its shareholders. As such, it provides limited liability to its investors and is a separate taxpayer with entirely different tax rates and rules than those applicable to individual taxpayers. Although the corporation as a separate entity has, potentially, a perpetual life, the continuation problems that plague other forms of closely held enterprises are often applicable to closely held corporations as well. From a practical standpoint, a closely held business, regardless of its form, cannot continue without the services of at least one key individual. In a closely held corporation, the key individual or individuals usually include the shareholders. The death, retirement, or disability of these key individuals threatens the future of the corporation. For this reason, the closely held corporation and its shareholders should consider adopting a buy-sell agreement.

Entity (Stock Redemption) Buy-Sell Agreement. Under a stock-redemption agreement the corporation is the "purchaser" of the stock at the death of a shareholder. Each shareholder subject to the agreement binds his or her estate to transfer the stock to the corporation in exchange for the required purchase price. Thus both the shareholders and corporation are parties to the stock redemption agreement. The actual form of transaction is that the corporation redeems a deceased shareholder�s stock in exchange for a redemption distribution. The corporation either retires the stock or holds it as treasury stock. This reduces the number of shares of stock outstanding in the corporation. From the surviving shareholder�s standpoint, the practical effect of a stock redemption is that the percentage ownership held by each surviving shareholder increases proportionately when a deceased shareholder�s stock is redeemed.

The tax treatment of a stock redemption is extremely complex and beyond the scope of this discussion. However, a stock redemption is treated as a distribution of cash or property from the corporation to a shareholder. Under many circumstances, the redemption distribution is treated as a taxable dividend to the redeemed shareholder. Under certain exceptions, a redemption is treated as a sale or exchange subject to capital gains. The reader should be aware that it is essential to qualify the stock redemption as a sale or exchange to avoid disastrous tax consequences to the redeemed shareholder�s estate. Generally speaking, a stock-redemption plan will not qualify for the desired sale-or-exchange treatment if family members of the decedent own stock in the corporation and plan to be the decedent�s successors in the corporation.

Another tax problem associated with the stock-redemption agreement is the loss of income tax cost basis for the surviving shareholders. Since the corporation is the purchaser in the stock-redemption agreement, the surviving shareholders will not be treated as contributors to the purchase. Thus the surviving shareholders will not receive an increase in their income tax basis in their stock since the corporation, not the shareholders, provides the purchase price.

Corporate Cross-Purchase Buy-Sell Agreements. The corporate cross-purchase agreement is analogous to the partnership cross-purchase agreement discussed earlier. That is, each shareholder agrees to purchase a specified percentage of the shares of stock held by a deceased shareholder at the time of death. Each shareholder must also agree to bind his or her estate to sell the stock owned at his or her death. The corporation is not a direct party to the buy-sell agreement. The corporation should, however, issue stock certificates endorsed with a statement that the stock is subject to the terms of the buy-sell agreement.

If few shareholders are involved, the cross-purchase agreement is advantageous from a tax standpoint in two respects. First, the sale of stock by a deceased shareholder�s estate will always be treated as a sale or exchange. Thus the estate gets favorable capital-gains tax treatment. This makes the cross-purchase agreement the preferable form of buy-sell agreement for a family corporation where a stock redemption would often result in taxable dividends to the estate. Second, the surviving shareholders are direct purchasers, and each receives income tax cost basis in his or her stock equal to the amount of the purchase price paid.

Stock-Redemption Agreements. The stock redemption buy-sell agreement requires that the corporation redeem a deceased shareholder�s shares of stock at his or her death. If life insurance is chosen as the agreement�s funding mechanism, the corporation should be the applicant, owner, and beneficiary of the policies. Ownership of the policies is particularly important for a corporation that does not have an abundance of retained earnings. Under most state corporate laws, a corporation cannot make a distribution of any kind to a shareholder, including a stock redemption, unless the corporation has adequate surplus. The receipt of life insurance proceeds at a shareholder�s death provides the necessary surplus to redeem the deceased shareholder�s stock. Therefore the corporation should acquire life insurance on the life of each shareholder who becomes a party to the agreement. To ensure that the death proceeds will be adequate to meet the corporation�s obligation, the stock-redemption agreement should be updated periodically to prevent the face amounts of life insurance coverage from becoming inadequate as the value of the corporation rises.

Cross-Purchase Agreements. The cross-purchase agreement provides that the surviving shareholders are obligated to buy a prearranged share of a deceased shareholder�s stock from the deceased�s estate. If life insurance is the chosen funding mechanism for the agreement, each shareholder should purchase adequate life insurance on the life of the other shareholders. Each individual shareholder then becomes owner, beneficiary, premium payer, and beneficiary for the life insurance policies covering the lives of the other shareholders. At a shareholder�s death the surviving shareholders will receive the death benefits from the policies and will transfer the death benefit proceeds to the deceased shareholder�s estate in exchange for the appropriate amount of his or her stock. Since individual shareholders must be relied upon to maintain the funding for agreement, there is often the concern that some parties will not live up to the terms of the contract. To ensure that the cross-purchase agreement is carried out, a trustee is often used as an overseer to hold the policies and consummate the purchase and sale of stock at a shareholder�s death.

A regular corporation, often referred to as a C corporation, is a separate taxpayer with different tax rules from those applicable for individual income tax purposes. One distinct tax rule is the corporate alternative minimum tax. The corporate AMT has a particular negative impact on COLI. The life insurance product generally is exempt from income taxes. That is, the cash surrender value build-up in a policy is usually not subject to current income taxes. In addition, the death proceeds are received by the named beneficiary tax free. However, the corporate AMT may result in additional taxes for a stock-redemption plan funded with life insurance.

As part of the Taxpayer Relief Act of 1997, "small corporations" will be exempt from the corporate AMT for tax years beginning after December 31, 1997. A small corporation is defined as a corporation that has average gross receipts of $5 million or less for the 3 taxable years that ended with its first taxable year beginning after December 31, 1996. For corporations not in existence for 3 years, the new law applies the $5 million test on the basis of the period during which the corporation was in existence.

In order to qualify for the AMT exemption, the corporation must qualify as a small corporation for 1997 (or its tax year beginning after December 31, 1996). If the company is not qualified as a small cooperation in that tax year (or its first tax year for corporations formed after 1996), it will never be eligible for the AMT exemption. Proper planning should be conducted for businesses that anticipate 3-year average gross receipts at or near $5 million. If possible, a corporation on the verge of exceeding this threshold should consider delaying receipts in order to meet the definition of a small corporation for AMT purposes.

Once a business is qualified as a small corporation, it continues to be a small corporation as long as its 3-year average gross receipts do not exceed $7.5 million. Therefore if the corporation meets the $5 million test in its 1997 tax year, in following tax years it can earn significantly more yet still qualify as a small corporation.

If a business entity loses it qualification as a small corporation for failure to comply with the $7.5 million test in future years, its AMT liability will be based on preferences and adjustments only on transactions the corporation entered into after losing its status as a small corporation.

The new law protects small corporations from the imposition of the AMT when COLI would otherwise create an ACE preference (for example, when COLI is used to fund corporate stock redemption buy-sell agreements). As long as the company qualifies as a small corporation, the AMT dies not apply and will not subject insurance proceeds (or increases in cash value) to taxation.

The AMT is a tax equal to 20 percent of the corporate alternative minimum taxable income (AMTI). AMTI is determined by adding a list of tax-preference items to the corporation�s regular taxable income. The corporation pays the AMT if it exceeds the corporation�s regular income tax liability for the year. Among the preferences added to AMTI is 75 percent of current adjusted earnings. COLI creates an increase in current adjusted earnings to the extent that the policy provides income not counted in the regular income tax base. COLI increases current adjusted earnings in the following manner:

Thus the current adjusted earnings preference will affect an insured stock-redemption agreement funded with COLI, and the AMT liability could have a significant impact on the agreement in the year of a shareholder�s death. The tax imposed as a result of the AMT could cause the stock-redemption agreement to be underfunded by the amount of such tax. A reasonable ballpark estimate is that the corporate AMT will result in the need to overfund the death benefit in policies funding corporate stock redemptions by an amount from 15 to 17 percent.

The corporate AMT also has a significant impact on the complexity of a corporation�s tax reporting. If COLI is owned by and payable to the corporation, a separate set of books must be maintained to track the AMT basis over the insurance policies� holding period. The normal federal income tax basis will apply if the policies are cash surrendered or exchanged in a manner that creates normal income taxes. The AMT basis, which will often be different from regular income tax basis, will apply solely to determine the AMT liability resulting from the corporation�s ownership of such policies.

For federal income tax reasons, many corporations make a special election to receive S corporation status. This election is particularly favorable for shareholders who desire a direct pass-through of tax items (that is, taxable income, deductions, and so forth) directly to the individual shareholders. The S corporation generally pays no tax at the corporate level, and shareholders are taxed similarly, although certainly not identically, to partners of a partnership. The reader should be aware of the growing importance of S corporations and the special factors that need to be considered for continuation planning for such entities.

Shareholders make the S corporation election for important tax reasons. It is imperative that they preserve this election to avoid adverse tax consequences. For this reason, continuation planning is particularly important for an S corporation. Actions that cause the S corporation to fail to meet the requirements for S status will cause termination of the S election. Unless the termination is deemed inadvertent by the IRS, a future S election will be unavailable for 5 years.

Only certain corporations are eligible for S elections. A corporation is ineligible for S status if it has

A mandatory buy-sell agreement operative on the death of an S corporation shareholder can prevent the transfer of such stock to ineligible shareholders. Either the standard stock-redemption or cross-purchase agreement will cause the deceased S corporation shareholder�s stock to be held by the entity or individuals who already qualify for the S election. Thus an effective buy-sell agreement for an S corporation prevents the termination of the S election by transfer to an ineligible shareholder. As with other buy-sell agreements, the provisions of the S corporation buy-sell agreement should be binding and enforceable on all parties.

Generally speaking, the cross-purchase arrangement will not change the tax implications of an S corporation buy-sell agreement. Since the entity is not involved in the agreement, the unusual tax characteristics of S corporations will not apply. Should a stock redemption agreement be adopted by the S corporation, the tax implications are distinctly different from those applicable to normal corporate stock-redemption agreements. The S corporation has its own unique tax accounting system for determining the reporting of tax items affecting the corporation. Generally, all income received by the S corporation will be reported proportionally by the shareholders of the S corporation on their individual income-tax returns. A stock-redemption agreement for the S corporation will normally be funded by policies owned by and payable to the corporation. Since such life insurance is an aftertax expense, the policies funding this stock redemption agreement will be paid for by dollars taxable to the individual shareholders. Thus, similar to a partnership entity buy-sell agreement, the S corporation shareholders pay for the funding of a stock redemption agreement in proportion to their ownership in the corporation. Finally, accounting rules that record the retained earnings of the S corporation are particularly complex. These accounting rules affect every aspect of the S corporation�s participation in a stock-redemption plan.