Buy-Sell Agreements: Keeping the Doors Open
September 2020 Newsletter | By: Ian Sachs, CFP®
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Many closely held businesses do not continue after the first generation due to a lack of succession planning. A buy-sell agreement can be an excellent way to provide for the future of the business.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a contract between two or more business partners that stipulates how a partner’s share of the business may be reassigned under various triggering events such as a death, disability, or retirement. Some additional events include transfer to a third party, termination of employment, involuntary transfer due to bankruptcy or divorce, business disputes, and incarceration.
A well-drafted and properly funded buy-sell agreement can protect the interests of the business owners and help the continuation of the business.
How Does a Buy-Sell Agreement Work?
Buy-sell agreements can take different forms, including: (1) entity purchase (aka stock redemption), (2) cross-purchase, and (3) “wait and see”. The best type of agreement depends on several factors, including the type of business structure and the number of owners.
An entity purchase agreement allows the company to buy out each partner, while a cross-purchase agreement allows each partner to buy out the surviving family. A wait and see agreement is a combination. Each option comes with a different set of considerations (e.g. cost basis), but all outcomes achieve the same end result.
Benefits of a Buy-Sell Agreement
- Create Liquidity. The surviving family of a business owner will continue to need cash to pay ordinary living expenses. There may also be an estate tax liability which could force the sale of a business below fair market value to pay these taxes, which are usually due nine months after the date of death.
- Set a Fair Selling Price. While all owners are active, a business valuation strategy is determined and can usually be negotiated on an arm’s-length basis. Once a business owner has left the business, the remaining owners hold most of the cards. This can make negations difficult when trying to come up with a fair sales price for the owner’s estate.
- Fix Value. A buy-sell agreement ordinarily sets the valuation for estate tax purposes. This can reduce the risk of costly valuation disputes among business owners or upon an estate tax audit.
- Maintain Harmony. The pressures of everyday life and business ownership can make it difficult for owners of closely held businesses to maintain friendships and camaraderie. After the family of a deceased owner enters the business, maintaining harmony becomes even more difficult. This can be mitigated with a buy-sell agreement which can protect the remaining owners from problems arising when the family of the deceased owner joins the business.
Ways to Fund a Buy-Sell Agreement
There are four ways to fund a buy-sell agreement at an owner’s death:
- Cash Method – The surviving partner(s) can use cash to buy the deceased partner’s share of the business. The downside to this method is that it can take many years to accumulate sufficient funds.
- Installment Method – Installments can also be used to pay the purchase price for the share of the business. This can result in a drain on annual business income and can be unstable for the surviving family because it is contingent on future business performance.
- Loan Method – The surviving partner(s) can obtain a loan to pay the purchase price for the share of the business. This method also relies on future business performance to pay back the loan plus interest.
- Insured Method – Life insurance can guarantee that tax-free cash will be available exactly when needed at the owner’s death.
If you own a business and have at least one partner, it’s important that you consider putting a buy-sell agreement in place. It does not have to be a time consuming or expensive process. The agreement protects your surviving family, business partners, and ultimately, will help keep the doors of your business open.
