Buy-sell agreements protect heirs' interests.

You are sole proprietor, partner or shareholder of a closed corporation and you ask, "What is a buy-sell agreement and why do I need one?"

First, a buy-sell agreement is a method of guaranteeing that the values you have built up in your business will be passed on to your spouse and family at the time of your death. Second, the agreement provides that the business will continue to operate after your death.

The most important aspect of the agreement is the guarantee. Why? Simply put, without the guarantee the heirs to your estate will not, except in rare circumstances, receive anywhere near 100 cents on the dollar for your interest in the business unless they are able to continue to operate it at a profit and sell it at their leisure in the open market.

If the heirs are forced to sell the business within a short period of time, they can realistically expect to receive anywhere from 25 to 85 cents on the dollar, and rarely more than that.

In the case of the sole proprietor, an agreement may not be feasible as it requires not only a seller but also a purchaser.

"What should be in the agreement to make it work?" is the next most frequently asked question. The document or agreement which will be drafted by a lawyer must contain three essential items.

First, there must be an obligation, not an option, on the part of the survivor to buy, and on the part of the estate of the deceased to sell. If this essential item is not included, then the guarantee fails.

Second, the price to be paid for the deceased's interest in the business must be specified.

A minimum price is usually specified at the time of the agreement. However, the price to be paid is not constant. The business is going to grow and become more profitable, isn't it? Therefore, there should also be written into the agreement a formula which will allow the heirs, the purchaser and the auditors to determine the actual value or price to be paid at the time of death, which is likely to be many years in the future.

Third, the agreement must also specify how the price is to be paid. In other words, you have to come up with $50,000 to buy your deceased partner's or shareholder's interest in the business. How are you going to do it? Will you pay cash, make payments over time, or is there some unusual method of purchasing which is not one of the above in whole or in combination?

The first method of solving the problem is for the purchaser to have the cash stashed away in a bank account, tax paid and waiting for the day when the purchase must be made under the agreement. In most cases this will not happen. Business people tend to roll any excess cash from their operations right back into those operations so that they can grow and prosper. Thus, when the time comes to buy the deceased's interest, there is a mad scramble.

Under the second method the survivor is faced with having to take more personal income, pay tax in a higher tax bracket, and then pay the agreed amount each month or year to the heirs of the deceased. Thus, the purchaser pays the price with 150-per-cent, more or less, dollars.

The third method is similar to the second, except in this case the purchasers create a long-term obligation with a banker instead of the heirs of the estate.

The first, second and third methods of paying the price for a business are practical and may be the way to solve the problem in certain circumstances.

The fourth method, while not too practical, is one that is occasionally suggested. The purchaser counts in this case on the doubtful possibility of winning one of the many lotteries currently in vogue. When investigated in any depth, most parties to a buy sell-agreement agree that this is just not the type of funding to count on with any degree of certainty.

The fifth method of creating the necessary money to meet the obligation under the agreement is with life insurance. This solution, in most instances, will prove to be the most efficient and economical way of guaranteeing the price to be paid. Why? Simply because the dollars required to meet the obligation are immediately available upon the death of a partner or shareholder.

The purchasers collect the proceeds of the life insurance, they pay the estate of the deceased and, in a very short period of time, everyone is satisfied.

Also, insurance will cost much less than any of the other methods of funding the agreement. Why? Because the price is paid in advance through insurance premiums and never will the purchasers pay 100 cents on the dollar to make the purchase price available when it is required, no matter now long the insurance is in force.

When the parties to the buy-sell agreement have determined that the most efficient and economical way to solve the funding problem is through the use of life insurance, then the question remains: "What type of life insurance should we use?"

The answer to this question is as varied as the businesses and business people who ask it.

Term insurance may be the way to solve the problem for the relatively small or new operation where every dollar counts.

For the more established and successful business operation, whole life insurance may be the way to go.

For businesses between the two extremes a combination of the two might be the answer. What is right for you may very well be totally inappropriate for your business neighbor down the street.

Perhaps the ideal solution to providing funding for your agreement is to use life insurance policies which will grow with your business. Frequently, the death benefit on this type of policy will grow with the rate of inflation.

If your business is growing faster than inflation, then you should have a rider on your policy which will allow for the purchase of more insurance when it is required, no matter what your state of health at that time.

Peter F. Woolnough, CLU, CHFC, is an associate of the estate service department of Canada Life Assurance Company in Sudbury.