Here are some common methods for setting a price for the business interest in a buy-sell agreement.

Fixed Price

A fixed price clearly stated in the agreement has the benefit of simplicity but may be impractical or unrealistic. As time passes, the business could be worth considerably more or considerably less. Consequently, unless the price is stated by a formula that is regularly adjusted, it may not be a fair or acceptable valuation when the transaction is carried out.

Formula Method

This approach is usually based on some type of capitalization of earnings formula. For example, it may be determined that the business is worth five times its average earnings. Objective factors are considered to arrive at the valuation figure, with allowances or adjustments for special circumstances or abnormalities of the business. Keep in mind the formula must be clearly stated in the buy-sell agreement.

Appraisal

The buy-sell agreement could stipulate that the business valuation be determined through appraisal by one, two, or even three independent appraisers. For example, the estate and the surviving owners could each hire appraisers to make the valuation, and if an agreement is not reached by these two, a third could be appointed to mediate or make the final determination. The agreement can provide specific guidelines for making an appraisal or the methods used could be left entirely to the discretion of the appraisers.

Combination Method

As the name implies, a combination of methods could be used for arriving at a valuation. A specified price could provide a starting point for the valuation with formula or appraisal methods used to adjust or modify the amount.

Life Insurance and Business Valuation

Naturally, the ultimate success of any buy-sell agreement will depend on the buyers having the necessary cash to fulfill their obligations. The death benefit provided by life insurance is an efficient method for obtaining these funds for three reasons.

It provides the funds precisely when they may be needed (assuming all premiums are paid when due and that there are no substantial loans or withdrawals).
It does not require a substantial number of months or years to build these funds.
It helps the buyers to meet their obligations cost-effectively, even when the time-value of money is taken into account.

There is an important point to remember about using insurance to help fund a buy-sell agreement. Death proceeds flowing into a corporation may actually increase the value of corporate stock. This factor should be considered in drawing up the agreement and establishing a method for valuation. In addition, when an entity buy-sell agreement is executed, the amount by which insurance death proceeds received by a corporation exceed net premiums paid increases the "adjusted current earnings" of the corporation. This is a tax preference item potentially subject to the corporate alternative minimum tax.

Tax Aspects Related to Business Valuation

The valuation of a business interest determines the amount a surviving owner or owners will pay for a deceased owner's interest. Recall that death proceeds received by the corporation may be subject to the corporate alternative minimum tax. A cross-purchase plan alleviates this concern, since the corporation would not be receiving the proceeds, and also result in a stepped-up basis for surviving owners.

The value of the deceased owner's business interest is included in his or her estate for federal estate tax purposes. For the buy-sell agreement to establish this value, the method of valuation must approximate the fair market value of the business interest. Generally, the formula must use recent earnings as the basis for the stock price.

Click here to jump to a discussion of a special deduction available through December 31, 2003, when an estate includes a family farm or business.

The Ultimate Value of Business Valuation

When closely held corporations establish a sound method for business valuation as part of a buy-sell agreement, everyone rests easier. Business owners are assured that adequate funds will be available to help purchase the interest of a deceased owner, and business continuity will not be disrupted. Further, each owner knows his or her heirs will receive fair treatment under the terms of the agreement.

Keep in mind that, as time passes, the value of the business may increase. That could mean additional life insurance coverage is needed to assure the availability of funds to fulfill the agreement.

Business valuation is a complex matter. While it is possible to follow IRS guidelines in making the valuation, it is impossible to say for certain that the IRS will be in 100% agreement when the estate is settled. That is why the valuation itself should be left to specialists in the field. Your role is to understand the process, know how life insurance fits into the picture, and work with clients to meet their specific funding needs.