Business owners often overlook the importance of stipulating what will happen to a partner’s business share if the partner dies, becomes disabled or incapacitated, or otherwise exits the company. A buy-sell agreement addresses vital questions and prevents things from getting ugly.
Without a binding agreement, owners put their business at risk of costly litigation, increased expenses, and loss of valuable time from issues that may arise among partners or surviving spouse(s).
What Is a Buy-Sell Agreement?
A buy-sell agreement between the business and its owners stipulates how a significant event like death, disability, divorce, incompetency, bankruptcy, or departure of a partner will impact the control and management of the business.
Here, the term “business” refers to all business types having more than one shareholder/partner, including limited liability companies, C- and S- corporations, and general and limited partnerships. The term “owner” refers to any owner of such a business, including partners, shareholders, or members in an LLC.
A buy-sell agreement addresses the questions of who, why, what, when, and where. So, a well-structured buy-sell agreement anticipates the intent and needs of the owners. It also expects potential conflicts if one or more partners wish to sell their shares in the business or are forced to dispose of them during a bankruptcy proceeding.
An effective buy-sell agreement answers questions like:
- When may a business sell an owner’s interest/share, and under what circumstances?
- May the business or other owners buy that interest before selling it to an outside party?
- How much should a buyer be charged to purchase that interest?
- Who can take the departing owner’s place?
A buy-sell agreement is also called a buyout agreement, a business will, a business prenup, a shareholder agreement, or a succession agreement.
Why Should a Business Have a Buy-Sell Agreement?
A buy-sell agreement offers several benefits when one or more partners exit the business:
- It facilitates the smooth and orderly transfer of wealth, ownership, and management after a partner dies or departs.
- It ensures that someone (the remaining owners or the business entity) is ready to consider the buyout of the business interest of the departing shareholder/owner.
- It provides a method of funding the buyout, establishes an acceptable purchase price, and sets the terms for payment for the deceased or withdrawing owner’s business share.
- It allows the business to continue, thus helping to retain the confidence of customers, employees, and creditors.
- It assures other owners that no third party or outside person will take over the deceased or departing owner’s business interest if the agreement specifies that the former partner’s interest cannot be sold to an outside party.
- It ensures that heirs of the deceased partner have a buyer for assets they may not necessarily know how to manage and provides the money to manage the estate’s expenses, taxes, debts, etc.
Pitfalls and Risks of NOT Having a Buy-Sell Agreement
A buy-sell agreement sets out the process and price for buying out an owner’s share of the business if one or more partners no longer want to be in business together or if one or more owners exit the business due to death, illness, injury, or other circumstance. Without this agreement in place, it isn’t easy to safeguard your business interests. Conflict may be costly, resulting in time-consuming lawsuits and court orders to dissolve the company, pay creditors (sometimes court intervention is needed to resolve credit issues), and split the proceeds according to the ownership percentage.
Other risks of not having a buy-sell agreement include:
- A partner’s death, disability, divorce, incompetency, bankruptcy, or departure may skew management and voting control of the business.
- The jobs of minority shareowners and other non-owner employees may be threatened.
- The deceased owner’s business interest may be locked up in probate, or a personal representative might become a voting owner.
- A deceased owner’s heirs have no guarantee of inheriting shares in the business and find themselves at the mercy of the surviving owners.
Rather than taking such risks, business owners should have a buy-sell agreement that lists events that could trigger a purchase of one owner’s interest. This should include funding for death and disability with insurance, so there’s money to pay the departing owner or their estate.
The buy-sell agreement should also include a provision for one owner or multiple owners to buy out another owner or owners if there is a break in management or if an owner wants to exit for personal reasons.
Primary Types of Buy-Sell Agreements
There are three primary types of buy-sell agreements:
The Redemption Agreement. Under the redemption agreement of buy-sell, the business entity (i.e., company) must purchase the interests/shares of the deceased or departing owner.
The Cross-Purchase Agreement. With cross-purchase agreements, surviving/remaining owners may buy the interest/shares of the deceased or selling ownership in the business.
The Hybrid Agreement. The hybrid agreement mixes the two benefits, with options allowing individual partners/shareholders to buy some portions and the business entity to purchase the remainder.
Critical Considerations to Select the Appropriate Buy-Sell Agreement
Number of Owners
With a redemption agreement, the business needs to purchase life insurance policies on all owners, with the corresponding death benefit approximating the value of each owner’s interest in the company. Therefore, in the event of an owner’s death, the business can purchase the deceased owner’s interest with the policy’s proceeds.
With a cross-purchase agreement, each owner must buy a life insurance policy on every other owner. The policy amount must be sufficient to cover the purchase price of each other owner’s interest in the business. So, if there are just two owners, each owner purchases a policy for the other, and there are only two policies. If there are six owners, the number of approaches to fund cross-purchase obligations exponentially increases to 30.
To minimize the downside of a high number of policies, owners can create a separate partnership or trust to purchase life insurance policies covering each owner. The proceeds that this partnership or trust collects must comply with the terms of the cross-purchase agreement.
The insurance premiums which the business or the owners pay to fund a buy-sell agreement are not tax-deductible. With proper planning, owners may use this to their advantage. For example, a C-corporation in a tax bracket lower than the owners’ can fund a redemption obligation and reduce the tax burden.
Alternative Minimum Tax (AMT)
With a redemption buy-sell agreement, a C-corporation may have to pay the AMT. Owners of an S-corporation, limited partnership, or LLC may be subject to personal alternative minimum tax in a cross-purchase buy-sell agreement. The IRS does not permit adjustment for insurance proceeds.
Type of Income
In a cross-purchase agreement, the proceeds are usually considered capital gains. However, a C-corporation may file a combination of ordinary income and capital gains with a redemption agreement. Special tax rules apply for a typical S corporation to determine whether a redemption must be treated as a sale or a dividend. Redemption as a dividend is treated as ordinary income. Understand the desires of the other owners when determining how the recipients of buyout proceeds will be taxed.
Accumulated Earnings Tax
When a C-corporation accumulates earnings to complete the obligations of the redemption agreement, it may have to pay accumulated earnings tax. But if the accumulated earnings are used to buy out a minority interest, it may not be subject to this tax.
Accumulated earnings tax also does not apply to C-corporations purchasing life insurance to fund a potential buyout. As there is no tax at the entry-level, S-corporations, LLCs, and limited partnerships do not pay this tax.
Life Insurance Amount
It is essential to consider the life insurance amount concerning the buyout price. In a C-corporation, the remaining owners will have to turn tax-free insurance proceeds into ordinary taxable income to get insurance proceeds above the interest’s value. However, excess profits received and distributed by an LLC, S-corporation, limited partnership, or the owners in a cross-purchase agreement remain tax-free.
The Hybrid Buy-Sell Agreement
A hybrid agreement gives flexible purchase options to the owners and the business. Either the company owners have the first option to purchase, with the second option going to the other. Therefore, when an event triggers, the owners can assess the capital needs of the business and the existing tax laws to choose appropriately for themselves and the business.
The order of options is essential to know if a buyout will be optional or mandated. Usually, buy-sell agreements give owners the first option to purchase; however, if they do not exercise this option, crafting the business’s obligation needs special care.
Just having a buy-sell agreement does not avoid all the risks and pitfalls of not having one. It’s important to select the most appropriate type of buy-sell agreement and make sure it’s thorough. Take special care to include the order of the options, the company’s obligations, the purchase terms, the purchase price, and other critical factors. Consult your tax attorney or get in touch with Value Scout professionals to ensure that the selected buy-sell agreement option incurs the lowest tax burden for all partners and the company.