What is a Business Buy Sell Agreement and How Can it Benefit my Business?

A BUY-SELL AGREEMENT CAN PROVIDE A SMOOTH TRANSFER OF YOUR OWNERSHIP INTEREST

Events like the retirement, disability or death of an owner don’t have to mean the end of the business. Business succession planning can provide for an orderly transition of ownership and business management, during lifetime or at death. One tool used in business succession planning is the buy-sell agreement. A properly designed buy-sell agreement can allow you to keep control of your business until retirement, disability, death or other specified event. We’ll provide an overview of buy-sell agreements, how they can be beneficial and both personal and business considerations to take into account.

Legal contract

A buy-sell agreement is a legal contract, common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. A buy-sell agreement is also referred to as a business continuation agreement, a stock purchase agreement, or a buyout agreement.

Establishes buyer for your business interest

A buy-sell agreement identifies a buyer or potential buyer of your business interest and the conditions under which a sale will occur. The buyer could be an individual or an entity, and there can be more than one buyer. Typically, once you are bound under a buy-sell agreement, you can’t sell your interest in the business to any party except the buyer named in the agreement. More frequently, the agreement involves rights of first refusal, so the potential to sell to a third party is possible.

Defines events triggering sale of business interest

Under the terms of a buy-sell agreement, the buyer may be legally obligated to buy your interest in the business from you (or your estate), and you (or your estate) may be legally obligated to sell your business interest at the occurrence of a specified triggering event. You, your advisors, and the other parties to the agreement will determine the triggers appropriate for your business situation. Possible triggering events include those shown in the following table:

There are several benefits to having a buy-sell agreement. Some of these benefits affect you, your family, or your estate, while others affect the business itself in terms of stability and how it is viewed by outside parties, such as bankers. When an owner of a closely held business dies and there is no continuation plan, the seller (for instance, your estate) is generally at a disadvantage and may be forced to accept a low price for the business interest, assuming a buyer can be found. A properly designed buy-sell agreement can protect your heirs by eliminating the possibility of a forced sale or the need for your family to rely on the business for income. The buyer and sale price are prearranged under the buy-sell agreement.

What happens when an owner dies?

Corporate law dictates that certain forms of business organizations terminate at the death of an owner. A buy-sell agreement can prevent the termination of your business at your death. The following table lists the common business forms, and what would happen at the death of an owner if there is no buy-sell agreement in place:

Personal Considerations

Provides a guaranteed buyer for your business interest (or how to avoid a fire sale)

When you die, your estate does not have to search for someone who is willing to buy your share of the business. Your estate will not be forced to sell your business interest at an unfairly low price to get the cash needed if your estate must pay estate taxes. Under the terms of the agreement, when any of the triggering events occur, there is a ready buyer for the share of the business. A buy-sell agreement spells out exactly who will buy your interest in the business, under what circumstances, and at what price.

Tip: For this to work, you must fund the buy-sell agreement.

Provides liquidity for the payment of estate taxes and other estate settlement expenses (but only if the agreement is funded)

Estate taxes, if owed, are due to the federal government nine months after death. In some states, the death taxes are due even sooner than that. The buy-sell agreement not only provides a buyer for the business interest but also specifies the value or valuation method, if the payment will be in a lump sum or installment, and when it will happen. If your estate is large and subject to estate taxes, your family will need enough cash to pay them. You want to be sure that they will be able to convert your portion of the business into cash quickly and at a fair price. Under a buy-sell agreement, the sale of the business interest can occur quickly, and your family can be spared the panic of just how to pay the estate taxes.

Caution: If the buyer does not have the cash or access to cash when needed for the buyout, the agreement won’t serve any useful purpose. Make sure that the agreement specifies the plan to fund the buy-sell agreement and, even more importantly, that the funding takes place.

Tip: The applicable exclusion amount effectively exempts a certain amount of your gross estates from federal estate tax liability. If your estate is worth less than this amount, you may not owe estate taxes, and the benefit of a buy-sell agreement to provide liquidity for estate taxes would not be of much importance to you. However, you still may want the other benefits of a buy-sell agreement such as a guaranteed buyer.

Avoids potential conflicts of interest between surviving owners (if any) and your heirs

At your death, there is a natural conflict of interest between your surviving co-owners (if any) and your heirs. Generally, it is in your heirs’ best interest to receive the largest amount of cash possible from the business. Likewise, it is generally in the surviving co-owners’ best interest to continue the business operation without interruption and to keep liquidation costs to a minimum. Without a prearranged agreement, the differing needs of your heirs and your surviving co-owners are likely to result in a dispute. A buy-sell agreement can ensure that your plans for your business and for your heirs are carried out as you intended and are not met with resistance.

Can establish the value of the business for estate tax purposes, if structured properly

The buy-sell agreement may, under the right circumstances, set the fair market value (FMV) of an interest in the business when the agreement is executed. When the agreement is structured properly, the IRS will accept the FMV as the taxable value if certain conditions are met.

Caution: Buy-sell agreements between family members or related parties can be subject to close scrutiny by the IRS. The definition of “family member” includes your spouse, parents of you and your spouse plus their lineal descendants including spouses, and any other “natural objects of the transferor’s bounty.”

Maintains stability of business operations

The buy-sell agreement specifies exactly who will continue as owners in the business. The agreement can be used to ensure that the people who have been running the business can continue to do so. It can ensure that the surviving co-owners will not be forced to accept outsiders into the business.

Improves creditworthiness of the business

A buy-sell agreement may increase the probability of the business continuing successfully after the death or withdrawal of an owner. From a creditor’s viewpoint, the continued existence of the business means the continued ability to meet outstanding loan payments. Creditors may view the business as more stable and the owners as responsible businesspeople, and may be more likely to extend credit to the business.

Maintains legal status of your S corporation, partnership, or professional corporation (if relevant)

A buy-sell agreement can protect S corporation status by preventing ineligible shareholders from buying shares of the corporation, preventing ownership by more than the maximum allowable number of shareholders, and complying with the one class of stock requirements. It can protect partnership status by avoiding liquidation at the death of a partner. In most states, nonprofessionals are not allowed to be stockholders in a professional corporation. Use of a buy-sell agreement can prevent a nonprofessional from becoming a stockholder in your business in violation of the law.

A buy-sell agreement can be a powerful tool in a business continuation plan. When coordinated with your estate and tax planning, a buy-sell agreement can provide a smooth transfer of your ownership interest. In addition to looking at your own personal goals for estate and tax planning, you must consider factors specific to your business before you can decide on a particular type of buy-sell agreement.

Setting up a buy-sell agreement can be very complex because it involves legal and tax issues. Don’t try to tackle this alone — get professional help from your attorney, tax advisor, and/or financial planner. Each party to the agreement should have his or her own attorney and advisors.

Once you have drafted your buy-sell agreement, don’t just put it away and forget about it. You and your buy-sell participants should review the agreement on a regular basis, perhaps yearly. You want to be sure that the agreement still meets your objectives. The valuation provisions may specify an annual valuation of the business.