An entity purchase agreement, also known as a stock redemption agreement, is a type of buy-sell agreement that businesses commonly use to ensure a smooth transfer of ownership when key events like the death, disability, retirement, or exit of a business owner occur. Unlike other buy-sell agreements where individual owners buy out the departing owner’s interest, the entity purchase agreement allows the business itself to repurchase the departing owner’s shares or ownership units.
One of the key features of an entity purchase agreement is its structure for ownership transfer. When a triggering event occurs, the business buys the departing owner’s interest directly from them or their estate. Typically, the business funds this buyout through life insurance policies taken out on the lives of the owners. Upon the death of an owner, the insurance proceeds go to the company, which uses those funds to buy the deceased owner’s shares. This setup ensures that business continuity is maintained. Ownership doesn’t pass to outside parties or heirs who may not be involved in the business, allowing the remaining owners to retain control while the departing owner’s family or beneficiaries are compensated fairly.
The agreement also includes a fixed valuation method for the business, which ensures that the buyout price is fair and avoids disputes about the company’s value. This is critical for maintaining business stability during what can be a disruptive transition.
The advantages of an entity purchase agreement are clear. It simplifies the buyout process since the business handles the repurchase, rather than relying on individual owners to do so. It ensures that control of the business remains with the existing owners, free from external interference. Moreover, if life insurance is used to fund the buyout, the premiums may be deductible, and the proceeds are generally received tax-free by the company.
However, there are also some potential drawbacks. When the business repurchases the departing owner’s shares, the remaining owners may see their ownership percentage increase, but they don’t get a “step-up” in basis, which could lead to higher capital gains taxes when they eventually sell their shares. Additionally, the company must ensure that it has adequate cash flow or insurance proceeds to fund the buyout, or else the buyout could strain its financial resources.
Entity purchase agreements are especially common in corporations and LLCs where ensuring the continuity of the business and having a clear ownership transfer process are essential for long-term success.
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