Buy-sell Agreements

Now that you have your business succession plan in place, you will want to create an agreement that dictates what happens to the business and your ownership interest if you can no longer continue as an owner-operator.  You and your surviving owners and managers will want to ensure continuity of ownership and management of the business after you are gone.  At the same time, everyone will want to ensure that the cash flow needs of the business are not strained by funding your buy-out, while you will want to protect your family by leaving them fair compensation for your share of the business.  A properly drafted buy-sell agreement can accomplish these goals.

What Events Trigger a Buy-out?  The most commonly anticipated events triggering either a mandatory or optional buy-out are death and disability.  The agreement should clearly define what “disability” is.  For example, an owner may be disabled if two licensed physicians, one of whom is his attending physician, certify in writing that the owner is no longer able to perform substantially all of the functions that he was performing before the onset of disability.  Moreover, there may be a minimum term before which disability formally occurs, such as 180 consecutive days of being absent from full-time work.

Another common event that triggers a buy-out may include the desire to sell the ownership interest to a third party.  In that event, the agreement may give the remaining owners or managers the ability to match the third party’s offer, purchase the interest in accordance with an agreed upon valuation formula, have the business repurchase the ownership interest or simply allow the sale to proceed.  If the owner wants to retire (e.g., after spending a minimum number of years in the business and/or reaching a specified retirement age), gets divorced or becomes bankrupt, you also may want to require the business or give the business (or the remaining owners or managers) the option to repurchase the owner’s interest at a set value with agreed upon terms.

Funding the Buy-Sell Agreement.   Owners of closely held businesses typically use one or both of two basic approaches to buy a departing owner’s business interest.  In a redemption arrangement, the business entity must buy the departing owner’s business interest.  In a cross-purchase arrangement, the remaining owners must buy the departing owner’s business interest.  The two approaches may be combined into a “wait-and-see” approach that attempts to give the entity and its owners maximum flexibility at the time of the triggering event (i.e., retirement, death or disability). Generally, the entity has the initial option to purchase the shares from the departing owner in an entity redemption format. The entity may or may not carry life or disability insurance on its owners. Should the advantages of an entity redemption listed above outweigh the disadvantages, then the entity can exercise its right to purchase the departing owner’s interest. If the entity fails to exercise its option, or purchases only part of the owner’s interest, then the remaining owners have an option or are required to purchase the departing owner’s interest in a cross-purchase format. The owners may or may not carry insurance for this purpose. To finance a mandatory buy-out, the entity or the remaining owners may want to purchase life insurance or disability buy-out insurance policies on each owner.

Although often simpler than a cross-purchase arrangement, a redemption poses many business and tax problems.  For example, if the business suffers a temporary reversal of fortune, its creditors may gain access to funds set aside for the redemption.  Even if the business’s creditors do not actively seek the funds, state law might prevent the redemption from happening if it makes the business technically insolvent.  Insurance-funded redemptions also may pose tax problems.  If a deceased owner holds more than 50% of the entity, the IRS might try to include in the owner’s gross estate the value that is attributable not only to the actual purchase price of his or her business interest, but also the portion of the life insurance proceeds received by the business.  If the entity is a C corporation, the life insurance will not increase the remaining owners’ tax basis in their shares as much as they could in a cross-purchase and may only partially increase the tax basis of the remaining owners in the case of partnerships and S corporations.  Further, if the company is a regular C corporation, the insurance proceeds may subject the corporation to alternative minimum tax.

Cross-purchase arrangements avoid many problems inherent in redemptions, but have their own issues.  Multiple insurance policies might be required to cover the interests of multiple owners, so that each owner has insurance on the other owners, a problem that multiplies radically as the number of owners increases.  For example, if there are three owners under a cross-purchase arrangement, six separate insurance policies at a minimum must be purchased to cover all of the owners.  In addition, the remaining owners may have their own personal creditors or divorce issues.  They also may want to keep the insurance proceeds, rather than spend the proceeds on the required purchase of the deceased owner’s business interest, either because they prefer cash to an additional business interest or because they believe the purchase price is too high.

To minimize the risks of both arrangements, you may want to place the insurance policies in a limited liability company (“LLC”) treated as a partnership for federal and state income tax purposes.  The owners of the business also will be the members or owners of the LLC.  A trust company or independent third party (such as a lawyer or CPA) could serve as manager of the LLC, taking charge of the policies and ensuring that the proceeds are used as intended.  Each owner would have an interest in the policies insuring the other members’ lives.  This technique was approved by the IRS for the first time in a 2007 private letter ruling (PLR 200747002, November 15, 2007).

Other Considerations.   In addition to structuring the buy-sell arrangement, you will need to determine how much insurance or cash flow is required to fund the buy-sell obligations.  Determining how much insurance is needed or how much to pay always is a function of valuing the business.  The goal of a valuation is to best approximate the business’s actual fair market value. Fair market value has been defined as the price at which property passes between a willing buyer and seller, neither under any compulsion to buy or sell, and both with knowledge of all relevant facts. Of course, where less than the entire ownership interest is being acquired, there might be discounts to reflect the lack of control or lack of marketability.  While the discussion of how to value a business is well beyond the scope of this column, you may want to utilize the services of a competent valuation professional to assist in the valuation process or in establishing a formula that can be used consistently from year-to-year.  Other provisions to consider including in your buy-sell agreement may be a noncompetition clause and a clause providing for the termination of the buy-sell agreement itself. Competent and experienced legal counsel should draft the agreement and advise each owner regarding their individual interests.