Your business needs a Buy-Sell Agreement
Before you begin operating a business with your partner a written agreement needs to be put into place. This agreement is called a – A buy-sell, or buyout agreement. This agreement protects business owners when a co-owner wants to leave the company and protects the owner who is left to operate the company. If a co-owner wants out of the business, wants to retire, wants to sell his shares to someone else, goes through a divorce, or passes away, a buyout agreement protects everyone’s interests, and outlines the terms for a buyout. Every day that value is added to a business without a plan for future transition, it increases the owners’ financial risk.
Intended Use of the Buy-Sell Agreement
Despite the name, buy-sell agreements have little to do with buying and selling companies. Actually, they are legal binding contracts between co-owners that dictate when owners can sell their interest, who can purchase an owner’s interest, and what price will be paid. These agreements are executed when an owner retires, becomes disabled, goes bankrupt, gets divorced, or dies. The main role of these agreements guide buyouts between the owners themselves. The agreement should be very specific in its nature. Nothing left to interpretation, if you will.
An important part of any buy-sell agreement is to specify what type of situations will cause a required or optional buyout of an owner’s interest by the other owners or the entity itself.
Death or disability
Desire to sell the interest to a third party. The agreement should provide that the terms of the potential sale be presented to the other owners, and that they be given the option of matching the offer made by the outsider, purchasing the shares in accordance with the valuation method and payment terms provided within the agreement, having the entity repurchase the shares issued in accordance with the valuation method provided for within the agreement or allowing the sale to be effectuated to the third party.
Selling to a third party would provide the other owners an option to purchase the selling owner’s interest. Typically, an owner’s retirement will generally trigger a mandatory buyout. However, these conditions under which an owner may have the right to retire, but will clearly state that the remaining owners, or the entity, would be compelled to buy that owner out are often a point of negotiation. Make sure that the agreement specifically states under what circumstances that a retirement may be executed. Once again, valuation methods and payment terms will be important issues, because there are no outside funding mechanisms, such as life or disability insurance, available to bear the cost. Furthermore, an evaluation of the business will be costly and must be a consideration in the agreement.
Divorce or bankruptcy.
Either of these events can subject the business to spouse interference or to creditors. To prevent this, the other owners should have the option to compel the affected owner to sell his shares to the remaining owners or the entity itself, in accordance with the payment terms and valuation methods. This should be clearly defined in the buy-sell agreement to protect each partner from the actions of the other.
Funding Upon an Owner’s Death
Entity redemption arrangement
The business entity is obligated to purchase the owner’s interest. To minimize the impact this might have on the entity’s liquidity needs, the entity can purchase life insurance policies on each owner. The business names itself as the beneficiary of each policy, and the face amount of the policy will be equal to the agreed-upon purchase price set in the buy-sell agreement. The proceeds should be received by the entity free of ordinary income taxes, pursuant to IRC section 101. This would be followed by a purchase of the owner’s interest by the entity with the life insurance proceeds.
- the life insurance proceeds might subject the corporation to the alternative minimum tax, however this can be discussed and added to the agreement.
- the surviving owners’ basis in their stock will not increase as a result of this arrangement. Should the entity be treated as a flowthrough entity for tax purposes, the surviving owners’ basis will partially increase, because all items of income, whether taxable or not, will cause all of the owners’ basis to increase in proportion to their profit-sharing interest.
- Family-owned (or an S corporation with accumulated earnings and profits), family attribution rules may cause the redemption of the owner’s shares to be treated as a dividend. This might prevent an owner from receiving a basis offset against the proceeds received. Assuming that the owner’s interest is completely redeemed by the corporation, however, the owner only needs to file an agreement with the IRS under which she may not reacquire any interest, nor participate in corporate affairs, for the next 10 years.
The insurance policies and proceeds would be subject to the entity’s creditors.
An owner having more than a 50% ownership, allows him to change the beneficiary(ies) of the policy. The life insurance payable upon the owner’s death, the proceeds become included in his estate.
Each owner of a business is personally obligated to purchase the departing owner’s interest. To provide the surviving owners with liquidity, each owner would own an insurance policy on the lives of the other owners. The proceeds of the life insurance policy would be received tax-free by the surviving owners and then used to purchase the deceased owner’s interest so that the ownership interest remains the same in relation to the other surviving owners.
- More than two owners, more insurance policies would have to be acquired than in the entity redemption arrangement.
- A corporation, a buy-sell agreement provides that the surviving shareholders purchase the life insurance policies may have future income-tax implications. More specifically, any future proceeds received by a surviving shareholder in excess of the purchase price and the subsequent premiums paid on these policies would result in taxable income to the new owners of the purchased policies. This is known as the “transfer for value” rule. This rule does not apply if the entity is unincorporated. Moreover, if the corporation itself acquired the policies, the transfer for value rules would not apply. There would, however, be an entity redemption arrangement in addition to the original cross-purchase arrangement upon the surviving owners’ death.
Plan For the Unknown
Planning for unforeseen events with a buy-sell agreement can assure owners in a closely held business that their interest in the business they built is secure regardless of any circumstances. The majority of the time this can be accomplished without putting excessive strain on the business’s cash flow, and ensuring that the business and its remaining owners continue to succeed.
In a buy-sell agreement there might be a noncompetition clause and a clause providing for the termination of the buy-sell agreement itself. Engel Law Offices can draft this document ensuring that all unforeseen events are addressed the best that they can be.