A buy-sell agreement is a contract between two or more business owners. It outlines rules for different business owner scenarios, including death, disability, divorce, bankruptcy, job loss, and retirement. These are referred to as “triggering events.”
A buy-sell agreement offers a strategic roadmap. It ensures a smooth transition of business interests for any owner. Consider getting a buy-sell agreement for your business if:
- Your business has two or more partners.
- You aim to safeguard against potential challenges. They might arise when an owner’s employment ends, retirement, divorce, disability, or death.
- You want to establish a systematic process. This procedure will ensure the seamless transfer of any owner’s business interest.
How Does a Buy-Sell Agreement Benefit Business Owners?
A buy-sell agreement benefits business owners in the following ways:
- Protect business ownership from undesirable individuals. For example, former spouses of a partner or a deceased stakeholder.
- Establish a dependable process for transferring a business interest.
- For estate taxes, it’s important to establish a fair way to value a departing owner’s stock.
- Put in place a funding mechanism to help the acquisition of an owner’s interest.
- Enforce provisions for the removal of owners under specific circumstances.
- Incorporate various governance or other provisions. (It ensures the ongoing continuity of business operations).
The buy-sell agreement outlines procedures for different triggering events. This ensures the company’s ownership remains as desired. The company’s best interests align with it. The agreement is a guarantee of fairness to the owners.
What Events Trigger Buy-Sell Agreements?
Death
Are beneficiaries entitled to the fair market value of the interest?
Do surviving owners wish beneficiaries to take part in the business?
Divorce
Is business interest considered an asset that is subject to division in the event of a divorce?
Disability
In the case of an owner’s disability, does the business need more capital?
Should other owners have the option to buy the disabled owner’s interest?
Withdrawal
What restrictions should govern the departure of an owner’s interest?
What circumstances can compel an owner to exit?
Bankruptcy
Do creditors hold the right to seize or encumber the interest of an insolvent owner?
What Are Valuation Methods Used by Companies?
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Fixed Price
Shareholders settle on a predetermined price outlined in the agreement.
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Independent Appraisal
Shareholders decide on the appraisal process when executing the agreement.
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Market Approach
Shareholders opt for using comparable from recently sold companies.
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Formula
It involves an asset-based or earnings-based formula to find out a fair value.
How Do These Agreements Get Financial Backing?
Various factors usually shape the selection of funding methods. These include the business’s size and structure, its tax bracket, and the number of owners. Also consider their ages, tax brackets, and ownership percentages.
The cash and/or credit available to a business plays a major role in influencing funding choices. The type of buy-sell agreement in place also influences the options.
Options For Funding Buy-Sell Agreements
Insurance Policy
Insurance policies can come in handy. A life or disability insurance payout helps the buyout of an owner’s shares.
Installment Note
An installment note makes the process more convenient. It involves gradual payments for the buyout of an owner’s shares. Such a process eases the financial burden on remaining owners and the business.
Cash
Using cash is a straightforward method. An owner can use reserve cash within the company, to fund a buyout.
Sale or Distribution of Company Assets
There are many excessive assets that a company owns. These are generally the assets not vital for the ongoing business operations. Selling or distributing them can generate the needed liquidity.
Leverage Company Assets
You can tap into a line of credit. You can also borrow from other assets. These are extra sources of liquidity.
Leveraged Employee Stock Ownership Plan (ESOP)
Selling to an ESOP establishes beneficial ownership for employees while providing tax advantages.
There are situations when an owner’s death triggers the buy-sell agreement. In this scenario, life insurance is a reliable funding method. Both a business and its stakeholders may own the policies. It provides flexibility in ownership structure.
Is A Buy-Sell Agreement Synonymous with A Business Succession Plan?
The buy-sell agreement functions more as a contingency plan compared to a business succession plan. In case of an emergency, it outlines actions to take.” If deviations or issues arise from the original plan, you should follow them. The terms of the buy-sell agreement may not align with your long-term succession and exit plan. This applies in most situations. It can involve transferring business, selling to an employee, or making it public.
Even so, certain scenarios exist. In these, a buy-sell agreement transforms into a comprehensive long-term succession plan. For example, a company with many owners could use a buy-sell agreement as a rule book.
It delineates the selection process for new owners. It outlines the method for their business entry. It establishes procedures for their eventual exit. It also covers the sale of ownership interests upon retirement.
Leveraging Life Insurance
A frequent catalyst for acquiring an owner’s interest is the demise of that owner. Facilitating such buyouts becomes straightforward by securing a life insurance policy. The business can orchestrate a redemption buy-out. Or the other owner(s) can plan a cross-purchase. The premiums don’t qualify for tax deductions. The resulting proceeds are often exempt from taxes.
Life insurance comes in two types. Term policies and those that accumulate cash surrender value. Businesses and owners choose term policies because they are helpful. This is because premiums can increase as the owner ages. The policy might also end at a certain age.
Cash surrender policies come in two distinct varieties. There are Variable Whole Life and Universal Life policies. These policies enable the internal accumulation of funds. They provide an avenue for investments in equities.
Owners of such policies can borrow against the cash surrender value. They have flexibility. This caters to buy-out obligations triggered while the owner is still alive. Furthermore, if an owner decides to exit, there is an opportunity to get the life insurance policies.
There are certain situations with more than two or three owners. Choosing a cross-purchase arrangement with life insurance might result in unfavorable tax implications.
Sometimes, when a partner dies, other partners buy their policies from the estate. It becomes a transfer for value. The death-benefits of the acquired policies become subject to income taxes. To avoid these challenges and explore other solutions, attorneys have created several options. They go beyond the usual cross-purchase buy-sell arrangement. Some examples include:
Trustee-Supported Cross-Purchase Agreements.
In this setup, a trustee buys life insurance policies for each participating shareholder. When a shareholder passes away, the trustee follows a structured process:
(1) collects the life insurance proceeds
(2) acquires stock from the estate of the deceased shareholder
(3) distributes the shares among the surviving shareholders.
The trustee can make the transfer easier by holding the shares for each partner. Even with these measures, it is unclear if the role of a trustee solves the transfer challenge.
The death of a shareholder sometimes triggers a transfer. This is a transfer of value of the deceased shareholder’s beneficial interest. From their insurance policies to the surviving shareholders.
Partnership-Supported Cross-Purchase Arrangements.
The transfer of value rule may apply to trustee arrangements. As a result, the “partnership” approach has gained popularity. This model mirrors the trustee arrangement. But it has a significant difference. Rather than establishing a trust, shareholders come together to form a partnership. The partnership then procures a single life insurance policy for each shareholder.
This setup circumvents transfer-for-value issues. The transfer of a life insurance policy to a partner is an exception to the transfer rule. The insured in this case is a partner.
The Bottom Line
A buy-sell agreement is a contract between business owners, which outlines how to handle business transitions due to events like death, disability, or retirement. It can ensure your business remains in the right hands and provide a method for valuing and transferring ownership stakes.
For businesses with multiple partners looking for a buy sell agreement, we recommend structuring this with a licensed financial advisor.
