Buy-Sell Agreements

There are several reasons for business owners to enter into buy-sell agreements with their partners or co-shareholders: (1) to create a market for the owner's business interest at certain triggering events such as death, disability or retirement; (2) to facilitate a smooth transition of management and control for the surviving or remaining owners; (3) to provide a mutually agreeable price and terms (so as to avoid litigation and friction); (4) to establish the value of the business for estate tax purposes; and (5) to provide the family of a deceased owner with liquidity rather than a non-marketable business interest.

A buy-sell agreement can be broken down into three major components. First, there are the triggering events that require a business owner to sell (or offer for sale) his or her interest in the business. Second is the purchase price for the business interest. The final component of a buy-sell agreement is the payment terms.

Structure

A buy-sell agreement may be an entity plan, a cross-purchase plan, or a wait-and-see plan. In the entity plan, the corporation, partnership, or LLC buys the deceased or withdrawing owner's interest. In the cross-purchase plan, the surviving or remaining shareholders, partners, or members agree to buy the interest of a deceased or withdrawing owner. In the wait-and-see plan, at the time a triggering event occurs, the owners agree among themselves whether they, the entity, or a combination of both will purchase the interest of a deceased or withdrawing owner. Which type of buy-sell plan is preferable depends on both tax and nontax issues.

Triggering Events

Most business owners think of buy-sell agreements in the context of what happens to their business interest on their death. However, a comprehensive buy-sell agreement will also include a number of other triggering events. For each such event, a market is created that might not otherwise exist in a closely held business, and the remaining owners are guaranteed control of the business without outside interference.

Next to death, the most common triggering events are total and permanent disability (usually following a one- to two-year waiting period), retirement or termination of employment, transfers to third parties, and deadlock. With respect to disability, a provision defining what constitutes total and permanent disability must be included in the buy-sell agreement. The agreement should also specify the normal retirement age. Under termination of employment, the agreement should cover both voluntary and involuntary terminations. Transfers to third parties should include not only sales but also gifts and involuntary transfers that might occur if a business owner divorces, is sued, or becomes bankrupt. Finally, a buy-sell agreement may be used to structure a fairly priced buy-out when the shareholders are deadlocked.

Purchase Price

There are a number of ways to value a closely held business in a buy-sell agreement. Many agreements use a fixed price subject to periodic revaluations and provide for an appraisal if the parties cannot agree to revalue or if they simply neglect to do so. However, valuation formulas are the predominant measuring device. Among the many formulas used are (1) net book value, (2) adjusted book value, (3) multiple of earnings, and (4) fair market value as determined by an independent appraiser or the corporation's accounting firm. A buy-sell agreement, when properly implemented, can fix the estate tax value of a deceased owner's business interest.

Payment Terms

A buy-sell agreement must set forth the terms on which the purchase price will be paid. Most agreements permit the purchase price to be paid in installments over a period ranging from three to ten years. Payments may be made monthly, quarterly, or annually, as the parties prefer. Installment-sale tax treatment is available to the selling business owner where he or she receives at least one payment after the close of the taxable year in which the sale occurs.

The down payment must also be specified. In most cases where the buy-sell agreement is funded with life insurance, 100 percent of the insurance proceeds will be required as the down payment for a deceased owner's business interest. For lifetime sales where insurance proceeds are not available, a down payment in the range of 15-30 percent is typical.

In installment sales, an interest rate must be specified. For buy-sell agreements involving nonfamily members, the interest rate is often a floating rate geared to the prime lending rate and can be adjusted annually or more frequently during the term of the installment note. For family businesses, it is not uncommon for the family members to want to use the lowest interest rate possible. In such a case, the interest rate should be set at the minimum rate required to avoid imputed interest or original issue discount problems (i.e., it should be set at the "applicable federal rate").

Funding the Buy-Sell Agreement

Guaranteeing sufficient funds with which to purchase the interest of a deceased, disabled or withdrawing business owner is an important part of buy-sell planning. A business has essentially five methods of funding a buy-sell agreement.

First, the funds can come from the business's assets or operating profits. However, most successful business owners do not keep large sums of liquid assets on hand. Instead, they put their money to work in their business.

Second, a sinking fund can be established. But such a fund may be inadequate if a business owner dies prematurely. In addition, for C corporations, establishing such a fund may expose the corporation to an accumulated earnings tax problem.

Third, the business can borrow the funds from a bank. The problem with borrowing, however, is that the loss of a key person might impair the business's credit-worthiness. In addition, the interest costs may be excessive and the interest expense may not be deductible.

Fourth, the business can pay the purchase price on installments. This approach presents the same problems for the business as borrowing from a bank. Moreover, the seller runs the risk that the business may fail and the payments stop.

The fifth and final method of funding a buy-sell agreement is life insurance. This approach offers the following advantages: (1) complete financing is guaranteed from the beginning; (2) the death proceeds are generally free from federal income taxes; (3) the policy's cash value can be used for a buyout due to retirement or disability; (4) it may be the most economical method because the premiums paid are usually a fraction of the death benefit; and (5) the business's credit position is strengthened.

Summary

A properly designed and funded buy-sell agreement provides assurance to the surviving or remaining owners that the business will continue in a successful manner. At the same time, it provides deceased, disabled or retiring owners with funds that will enable them to meet their needs and pay their estate settlement costs. Overall, a buy-sell agreement gives the business's owners, employees, suppliers, customers, lenders and bonding agents comfort and security that the business will successfully survive the death, disability or retirement of one or more of its owners.

For more articles on estate and business succession planning, please visit the author's website, www.disinherit-irs.com, and click on "Advisor Resources".

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Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.