A Redemption Buy-Sell Agreement is a contract between a Company and an owner(s) in which the company repurchases the owner’s interest from the owner. It is one of the most common buy/sell agreements restricting owners from transferring ownership interests in a tightly-knit business. This form provides an orderly and planned transfer of business interests. Typically, these agreements are used in corporations, limited liability companies, and partnerships.
Owners within a close company may wish to instill a redemption agreement for several reasons, such as ensuring business continuity, creating a market for close company interest, or offering liquidity to the estate of a deceased owner. However, certain restrictions and disadvantages may come with this type of agreement.
How a Redemption Buy-Sell Agreement Works
Here’s how a redemption agreement works:
- Draft and sign an agreement by all the parties involved, including the company’s owner(s) and potential buyers.
- Outline the terms for selling a company’s interests in case of a triggering event, such as an owner’s death, disability, or retirement.
- Establish a purchase price for the company’s interests and set rules for determining its value.
- Include provisions for funding the purchase, such as life insurance policies or installment payments.
- When a triggering event occurs, the buyer must purchase the company’s interests at the predetermined price.
- The buyer must pay the purchase price, and the seller must transfer the company’s interests to the buyer.
- Include restrictions on who can buy the company’s interests, such as limiting ownership to existing owners or their family members.
- Specify the purchase price calculation using a formula based on the company’s earnings or assets.
- Include a provision for resolving disputes during the sale process.
Life Insurance in a Redemption Buy-Sell Agreement
In a redemption agreement, the owner(s) must purchase life insurance policies in an amount equal to their ownership interest. However, the company must pay the premiums on the life insurance policies and will be listed as the policy owner(s). This way, the company can ensure that there will be enough funds available to purchase the departing owner’s interests in case of death.
- The amount of life insurance coverage should be reviewed periodically to ensure that it is sufficient to cover the value of each owner’s interests in the company. It is important to remember that the value of the interests may change over time due to various factors, such as business growth or economic trends.
- The life insurance policies should be structured in a way that allows for immediate access to the death benefit to fund the purchase of the departing owner’s interests. The policies can be either term or permanent life insurance, depending on the needs of the company and the owner(s).
- The premiums paid by the company on the life insurance policies are considered taxable income to the owners. Therefore, the tax implications should be carefully discussed with a tax professional.
In summary, this document requires the owners to purchase life insurance policies to fund the purchase of a departing owner’s interests. The company pays the premiums on the policies and is listed as the policy owner(s). The amount of life insurance coverage should be periodically reviewed to ensure sufficient, and the tax implications should be carefully considered.
Advantages and Disadvantages
When making important decisions for your business, it’s essential to weigh the advantages and disadvantages carefully. This holds particularly true when deciding whether a Redemption Buy-Sell Agreement is the right option for you. While there are benefits to such agreements, there are also drawbacks to consider.
One way to make an informed decision is to examine the protocol and considerations for future change, such as whether an appraisal occurs during the triggering event or if the business sells for a set percentage. Below, you can find the advantages and disadvantages:
- Provides a clear plan for the transfer of business ownership in case of a triggering event, such as the death or disability of an owner.
- It can be used to avoid conflicts between owners and their heirs or family members.
- Allows owners to control who can buy the stocks, preventing unwanted third-party ownership.
- The purchase price may become outdated if a specific price is stated, resulting in problems.
- There may be issues with the economy’s condition, and business value may decrease significantly.
- The business could also increase in value substantially, resulting in an unrealistic selling price.
- It can be complex and costly to set up and maintain.
- The agreement may limit an owner’s ability to sell their interests.