Question 1

What is a redemption buy-sell agreement?

Accepted Answer

A redemption (or entity purchase) buy-sell agreement is a contract between a company and its owners under which the company itself — rather than the individual co-owners — agrees to repurchase a departing owner's equity interest upon the occurrence of a triggering event such as death, disability, retirement, or voluntary withdrawal. The company typically funds this obligation through corporate-owned life insurance, a sinking fund, or operating cash, and the transaction results in the departing owner being cashed out while the remaining owners' relative ownership percentages increase proportionally.

Question 2

How does a redemption agreement differ from a cross-purchase agreement?

Accepted Answer

In a redemption agreement, the company itself buys back the departing owner's shares, using corporate funds or corporate-owned insurance. In a cross-purchase agreement, the individual remaining owners personally purchase the shares using their own funds and individually owned insurance. Redemption agreements are operationally simpler — only one set of insurance policies is needed instead of the n(n-1) policies required for cross-purchase — but they do not give the remaining owners a basis step-up in their existing shares, and they can trigger corporate tax issues such as accumulated earnings tax concerns.

Question 3

When is a redemption structure better than a cross-purchase?

Accepted Answer

A redemption structure is typically better for companies with many owners (five or more), where the administrative burden of maintaining cross-purchase insurance policies becomes unwieldy. It is also simpler when the company has plentiful cash or can easily obtain financing, when the owners do not want to personally manage insurance policies on each other, when all owners are in similar tax brackets, and when the basis step-up advantage of cross-purchase is less important because the owners expect to hold their interests for a long time or until death.

Question 4

How is the redemption price determined?

Accepted Answer

The redemption price is determined using the valuation method specified in the agreement. Common methods include a fixed price updated annually by the board, a formula based on book value plus goodwill or a multiple of earnings, an independent appraisal by a qualified business valuation professional, or a hybrid approach. The agreement should specify how often the valuation must be updated, how disputes about valuation will be resolved, and whether any adjustments apply for minority interest discounts, lack of marketability, or key-person losses.

Question 5

Can corporate-owned life insurance fund a redemption?

Accepted Answer

Yes. Corporate-owned life insurance (COLI) is the most common funding mechanism for death-triggered redemptions. The company owns and is the beneficiary of a life insurance policy on each owner. When an owner dies, the company receives the tax-free death benefit and uses it to redeem the deceased owner's shares from their estate. Under the COLI best practices rules enacted in 2006, the company must provide advance notice to the insured, obtain their consent, and satisfy certain ongoing notice and consent requirements to avoid the death benefit becoming taxable.

Question 6

What tax consequences apply to a corporate redemption?

Accepted Answer

The tax consequences depend on whether the redemption qualifies as a sale under IRC Section 302 or is treated as a dividend distribution. If the redemption is a complete termination of the shareholder's interest, or if it meets one of the tests for sale treatment (substantially disproportionate reduction or not essentially equivalent to a dividend), the departing shareholder recognizes capital gain equal to the difference between the redemption price and their basis. If the redemption does not qualify for sale treatment, it may be taxed as an ordinary dividend — a much less favorable outcome. For S-corporations, the rules are somewhat different because of the pass-through tax treatment.

Question 7

Does a redemption cause the remaining owners to get a basis step-up?

Accepted Answer

No. Unlike a cross-purchase, a corporate redemption does not give the remaining owners a basis step-up in their existing shares. The remaining owners' basis in their shares remains unchanged, but their ownership percentage increases because there are fewer shares outstanding after the redemption. This means that when the remaining owners eventually sell their shares, their capital gain will be higher than it would have been under a cross-purchase structure. The lack of basis step-up is the primary tax disadvantage of redemption compared to cross-purchase.

Question 8

What are the accumulated earnings tax implications?

Accepted Answer

C-corporations are subject to the accumulated earnings tax under IRC Section 531 if they accumulate earnings beyond the reasonable needs of the business. Funding a redemption buy-sell obligation is generally considered a reasonable business need, so the company can typically set aside cash or maintain insurance for this purpose without triggering the accumulated earnings tax. However, over-accumulation can still create risks, and careful documentation of the business purpose for accumulated funds is important. S-corporations are not subject to the accumulated earnings tax because their earnings are passed through to shareholders annually.

Question 9

Are there restrictions on when a corporation can redeem its own shares?

Accepted Answer

Yes. State corporation laws impose restrictions on the ability of a corporation to redeem its own shares, typically requiring that the redemption not render the corporation insolvent or impair its capital. Under the Model Business Corporation Act, a distribution (including a redemption) is prohibited if it would leave the corporation unable to pay its debts as they become due, or if the corporation's total assets would be less than its total liabilities plus any preferential rights of superior classes of stock. These solvency tests must be satisfied at the time of the redemption.

Question 10

What happens if the company doesn't have enough cash to complete the redemption?

Accepted Answer

If the company lacks sufficient cash to fund the full redemption, the agreement should include installment payment provisions that allow the redemption to occur over a period of years with reasonable interest. The departing owner (or estate) typically receives a promissory note secured by the redeemed shares, the company's assets, or personal guarantees from the remaining owners. Without such fallback provisions, the redemption obligation may be legally unenforceable if it would render the company insolvent, leaving the departing owner's heirs without liquidity.

Question 11

Can the agreement include a non-compete provision?

Accepted Answer

Yes. Redemption agreements commonly include non-compete, non-solicitation, and confidentiality provisions that protect the company (and the remaining owners) after a buyout. These provisions prevent the departing owner from immediately setting up a competing venture or poaching customers and employees. Non-compete provisions tied to a business sale (including a buy-sell redemption) are generally more enforceable than non-competes in pure employment contexts because courts recognize that the purchase price compensates the seller for the value of the goodwill that the non-compete protects.

Question 12

How often should a redemption agreement be reviewed?

Accepted Answer

A redemption buy-sell agreement should be reviewed at least annually and updated whenever there is a significant change in the business, ownership, or applicable law. Key review triggers include changes in the company's value; new owners joining or existing owners leaving; changes in tax law (particularly changes to IRC Sections 302, 318, or 2703); updates to insurance coverage; significant changes in business operations or capitalization; and major personal events affecting any owner. Agreements that have not been updated for many years often contain outdated valuations, stale funding assumptions, or provisions that conflict with current law.

Question 13

What triggers a redemption buy-sell agreement?

Accepted Answer

Common triggering events include: death of an owner (typically funded by corporate-owned life insurance), permanent disability, retirement, voluntary withdrawal, involuntary termination of employment, loss of professional license, divorce, personal bankruptcy, criminal conviction, and material breach of the shareholder or operating agreement. Each trigger should be precisely defined in the agreement, and the valuation and funding provisions may differ depending on which trigger applies. The agreement should also specify notice requirements, the procedural steps for completing the redemption, and any dispute-resolution mechanisms.

Free Redemption Buy-Sell Agreement Forms

What Is a Redemption Buy-Sell Agreement?

Operational Simplicity

Company Funding

Scalable to Many Owners

Redemption Agreement Form Preview

Stock Redemption Agreement

Section 1: The Parties

Section 2: Triggering Events

Section 3: Valuation

Section 4: Corporate-Owned Life Insurance

Section 5: Execution

How a Redemption Buy-Sell Works

Redemption vs Cross-Purchase Agreement

Triggering Events

Death of a Shareholder

Permanent Disability

Retirement

Divorce

Bankruptcy or Insolvency

Termination of Employment

Voluntary Withdrawal

Material Breach

Valuation Methods

Fixed Price (Agreed Value)

Formula-Based

Independent Appraisal

Hybrid Method

Funding the Redemption

Section 101(j) COLI Notice and Consent

How to Create a Redemption Agreement

Identify the Company and All Owners

Define the Triggering Events

Choose a Valuation Method

Establish Corporate-Owned Funding

Address Section 302 Sale Treatment

Include Solvency Protections

Add Transfer Restrictions and First Refusal

Include Non-Compete and Confidentiality

Get Corporate and Shareholder Approvals

Review and Update Annually

Key Components

Tax Implications

Section 302 Sale vs Dividend Analysis

Accumulated Earnings Tax

COLI Tax Treatment

No Basis Step-Up

Sample Redemption Agreement

STOCK REDEMPTION AGREEMENT

Frequently Asked Questions

Official Resources

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