Key Takeaways
- Buy-sell agreements establish predetermined terms for ownership transfer upon death, disability, retirement, or departure; the Connelly v. IRS Supreme Court decision (2024) significantly impacts entity redemption agreement valuations
- Cross-purchase agreements have remaining owners buy deceased owner's shares (stepped-up basis); entity/stock redemption has the company buy shares (no basis step-up for survivors)
- Common valuation methods include book value, capitalization of earnings (earnings/cap rate), discounted cash flow, and FMV appraisals; arm's-length agreements may fix estate tax value
- Section 303 stock redemptions allow estates to redeem stock to pay death taxes without dividend treatment if stock exceeds 35% of adjusted gross estate
- ESOPs can provide tax-advantaged succession by selling to employees; sellers can defer capital gains by reinvesting in qualified replacement property within 12 months
Business Succession Planning
Business succession planning ensures the orderly transfer of business ownership upon an owner's death, disability, retirement, or voluntary departure. For CFP professionals, understanding buy-sell agreements, funding mechanisms, valuation methods, and tax-advantaged transfer strategies is essential for serving business-owner clients.
Buy-Sell Agreements
A buy-sell agreement is a legally binding contract that establishes the terms under which business ownership can or must be transferred. These agreements answer critical questions: Who can buy? At what price? Under what circumstances?
Types of Buy-Sell Agreements
| Agreement Type | Purchaser | Policies Needed | Basis Treatment |
|---|---|---|---|
| Cross-Purchase | Remaining owners | Each owner insures others (N x (N-1) policies for N owners) | Purchasers get stepped-up basis |
| Entity Redemption | The business entity | Company insures each owner (N policies) | No basis change for survivors |
| Hybrid (Wait-and-See) | Entity first option, then owners | Flexible based on circumstances | Depends on which party purchases |
Cross-Purchase Agreement
In a cross-purchase agreement, each owner agrees to purchase the departing owner's share, and each owner typically purchases life insurance on the other owners.
Example with 3 Owners:
- Each owner buys a policy on each of the other 2 owners
- Total policies needed: 3 x 2 = 6 policies
- Upon death, surviving owners use insurance proceeds to buy deceased's share
Advantages:
- Surviving owners receive cost basis equal to purchase price
- Insurance proceeds received income-tax-free by individuals
- No attribution issues for family redemptions
Disadvantages:
- Number of policies grows geometrically (10 owners = 90 policies)
- Unequal premium burden if age/health differences exist
- Coordination challenges with multiple policies
Entity Redemption (Stock Redemption)
In an entity redemption agreement, the business itself agrees to purchase the departing owner's shares. The company owns and is beneficiary of life insurance on each owner.
Example with 3 Owners:
- Company buys one policy on each owner (3 policies total)
- Upon death, company uses insurance proceeds to redeem deceased's shares
- Remaining owners' percentage ownership automatically increases
Advantages:
- Simpler - fewer policies needed (one per owner)
- Premiums paid by business (potentially deductible compensation)
- Easier to administer with multiple owners
Disadvantages:
- No basis step-up for surviving owners
- Insurance proceeds may increase corporate value for estate tax
- Alternative minimum tax considerations for C corporations
Connelly v. IRS: Critical 2024 Supreme Court Decision
The Connelly v. United States Supreme Court decision (2024) significantly impacts entity redemption agreements:
Key Holding: Life insurance proceeds owned by a corporation to fund a buy-sell agreement increase the corporation's fair market value for estate tax purposes, even if the proceeds are obligated to redeem the deceased shareholder's stock.
Implications:
- Entity redemption agreements may result in higher estate tax than anticipated
- The obligation to use insurance proceeds for redemption does NOT offset the value increase
- Cross-purchase agreements avoid this issue (insurance owned by individuals, not entity)
Planning Response:
- Review all existing entity redemption agreements
- Consider converting to cross-purchase or hybrid structures
- Evaluate using an insurance partnership or LLC to hold policies
- Ensure adequate life insurance to cover both redemption AND increased estate tax
Hybrid (Wait-and-See) Agreement
A hybrid agreement gives the entity the first option to purchase, with remaining owners having the right if the entity declines. This provides flexibility while potentially optimizing tax outcomes.
Funding Mechanisms
Life Insurance Funding
Life insurance is the most common funding mechanism for buy-sell agreements:
| Funding Method | Advantages | Disadvantages |
|---|---|---|
| Life Insurance | Immediate liquidity, tax-free proceeds | Premium cost, insurability issues |
| Installment Notes | No upfront cost | Cash flow burden on purchaser |
| Sinking Fund | Company-controlled | May be inadequate, opportunity cost |
| Combination | Flexibility | Complexity |
Key Insurance Considerations
- Policy ownership: Determines estate tax treatment (Connelly implications)
- Premium payer: Cross-purchase (individuals) vs. entity redemption (company)
- Beneficiary designation: Must align with agreement terms
- Policy amount: Should match valuation formula or expected FMV
- Policy type: Term (lower cost) vs. permanent (builds cash value)
Installment Notes
When insurance is unavailable or insufficient, the purchasing party may pay with an installment note:
- Spread purchase price over years (typically 5-15 years)
- Interest payments may be tax-deductible to buyer
- Seller (or estate) receives income over time
- Security interest in business shares typically required
Sinking Fund
A sinking fund involves setting aside money over time to fund future buyouts:
- No insurance premium cost
- May not keep pace with business value growth
- Opportunity cost of funds
- Not suitable for unexpected death/disability
Valuation Methods
Accurate valuation is critical for buy-sell agreements. The IRS may challenge valuations that appear designed to minimize estate taxes.
Common Valuation Approaches
| Method | Formula/Approach | Best For |
|---|---|---|
| Book Value | Assets - Liabilities | Asset-intensive businesses |
| Adjusted Book Value | Book value + appreciation adjustments | Real estate, equipment-heavy |
| Capitalization of Earnings | Earnings / Capitalization Rate | Stable, profitable businesses |
| Discounted Cash Flow | PV of projected cash flows | Growth companies |
| Comparable Sales | Multiple of revenue or EBITDA | When market data available |
| Appraisal (FMV) | Independent valuation | Arms-length validation |
Capitalization of Earnings Example
| Component | Value |
|---|---|
| Average Annual Earnings | $500,000 |
| Capitalization Rate | 20% |
| Indicated Value | $2,500,000 |
Calculation: $500,000 / 0.20 = $2,500,000
The capitalization rate reflects risk - higher risk = higher rate = lower value.
Estate Tax Valuation Requirements
For a buy-sell agreement to establish value for estate tax purposes, it must:
- Be a bona fide business arrangement (not just estate planning device)
- Not be a device to transfer property to family members for less than FMV
- Have terms comparable to arm's-length transactions
Fixed-price agreements between unrelated parties generally control estate tax value. Family agreements receive greater scrutiny.
Family Succession Strategies
Gifting Strategies
Annual exclusion gifts: Transfer small ownership percentages annually
- 2025 annual exclusion: $19,000 per donee ($38,000 if spouse joins)
- Valuation discounts may apply (minority interest, lack of marketability)
- Reduces taxable estate over time
Lifetime exemption gifts: Use lifetime gift/estate exemption
- 2025 exemption: $13.99 million per person
- 2026 exemption: $15 million per person (OBBBA made higher exemption permanent with inflation adjustments starting 2027)
Installment Sales
Selling business interests to family members via installment note:
- No gift tax if sale at fair market value
- Interest income to seller; potentially deductible to buyer
- Removes future appreciation from seller's estate
- AFR (Applicable Federal Rate) sets minimum interest rate
Grantor Retained Annuity Trust (GRAT)
A GRAT transfers business interests to an irrevocable trust while the grantor retains an annuity:
| GRAT Feature | Detail |
|---|---|
| Structure | Grantor transfers assets, receives fixed annuity payments |
| Gift Tax | Only gift is value exceeding retained annuity (can be "zeroed out") |
| Estate Tax | Assets pass to beneficiaries at end of term, outside estate |
| Risk | Grantor must survive the term; IRS Section 7520 rate affects success |
Example: A business owner transfers $5 million in company stock to a 10-year GRAT. If the business grows faster than the Section 7520 rate, the excess passes to heirs gift-tax-free.
Intentionally Defective Grantor Trust (IDGT)
An IDGT combines grantor trust income tax treatment with completed gift status:
- Sale to IDGT is not a taxable transaction (grantor trust rules)
- Grantor pays income tax on trust earnings (further reducing estate)
- Appreciation after sale passes to beneficiaries estate-tax-free
Key Person Insurance
Key person insurance protects a business against the financial loss from losing a vital employee or owner.
| Key Person Insurance Feature | Detail |
|---|---|
| Policy Owner | The business |
| Beneficiary | The business |
| Insured | Key employee or owner |
| Use of Proceeds | Replace lost revenue, recruit replacement, repay debt |
| Tax Treatment | Premiums not deductible; proceeds generally tax-free |
Determining Key Person Value
Common approaches:
- Multiple of compensation (5-10x salary)
- Contribution to revenue or profits
- Replacement cost (recruiting, training, lost productivity)
- Loan requirements (lenders may require coverage)
Section 303 Stock Redemption
IRC Section 303 allows estates holding closely held stock to redeem shares to pay death taxes and estate administration expenses with sale (not dividend) treatment.
Section 303 Requirements
| Requirement | Detail |
|---|---|
| Minimum ownership | Stock must exceed 35% of adjusted gross estate (estate less debts/expenses) |
| Maximum redemption | Limited to federal and state death taxes plus funeral/administration expenses |
| Timing | Within 3 years and 90 days of filing estate tax return |
| Tax treatment | Sale/exchange treatment (capital gain, not dividend) |
| Basis | Stepped-up basis at death typically means no taxable gain |
Section 303 Planning
- If ownership is below 35%, consider lifetime gifts of other assets (not stock) to reduce estate
- Section 2035 adds back gifts made within 3 years of death
- Provides liquidity without forced business sale
- Works well with buy-sell agreements
ESOP Succession
An Employee Stock Ownership Plan (ESOP) can provide a tax-advantaged exit strategy for business owners.
ESOP Benefits for Sellers
| Benefit | Detail |
|---|---|
| Capital gains deferral | Seller can defer gains by purchasing Qualified Replacement Property (QRP) within 12 months |
| No immediate cash outlay | ESOP can borrow to purchase shares (leveraged ESOP) |
| Tax deductibility | Company contributions to repay ESOP loan are tax-deductible |
| Gradual transition | Seller can sell partial interest over time |
ESOP Requirements for Tax Deferral
- Must be a C corporation (S corps don't qualify for Section 1042 deferral)
- ESOP must own at least 30% of company stock after sale
- Seller must have held stock for at least 3 years
- Qualified Replacement Property must be purchased within 15-month period (3 months before to 12 months after the sale)
- Seller cannot be an employee of the company
ESOP Considerations
Advantages:
- Creates buyer (employees) when no external buyer exists
- Maintains company culture and employee motivation
- Tax-efficient for both seller and company
Disadvantages:
- Complex and expensive to establish and maintain
- Ongoing valuation requirements
- ERISA fiduciary responsibilities
- May not achieve full fair market value
On the CFP Exam
Expect questions testing your ability to:
- Compare cross-purchase vs. entity redemption agreements and their tax implications
- Apply the Connelly decision to entity redemption valuation scenarios
- Calculate business value using capitalization of earnings and other methods
- Identify Section 303 eligibility requirements (35% threshold, timing, amount limits)
- Evaluate ESOP succession as an exit strategy
- Recommend appropriate buy-sell agreement structures based on owner characteristics
Following the Connelly v. IRS Supreme Court decision, a C corporation owns a $3 million life insurance policy on its sole shareholder to fund an entity redemption buy-sell agreement. The corporation's operating business value is $7 million. For estate tax purposes, what is the likely value of the deceased shareholder's stock?
A business owner dies with an adjusted gross estate of $8 million, of which $3 million is closely held stock. The estate owes $500,000 in federal estate taxes and $100,000 in administration expenses. Can the estate use a Section 303 stock redemption, and if so, what is the maximum amount?
A business has 4 equal owners. They are deciding between a cross-purchase agreement and an entity redemption agreement. How many life insurance policies would be required under each structure?