What Is a Buy-Sell Agreement?
What Is a Buy-Sell Agreement
What is a buy-sell agreement? A buy-sell agreement allows for the mandatory purchase of an owner’s interest in the business. Purchasers may include shareholders and/or the business itself.
The 5 D’s
The events that trigger a buy-sell agreement include the 5 D’s:
1) Death
2) Disability
3) Disagreement
3) Divorce
4) Deadbeat
Usually a Key Person triggers one of the Five D’s. A key person is essential to the business as opposed to such person’s spouse or other family member.
Integrity Agreement
Careful planning includes a non-judicial mechanism to resolve conflicts or disputes that may arise in a business. An Integrity Agreement at Durfee Law Group provides up to 4 Steps to a non-judicial resolution:
1) Communication
2) Negotiation
3) Mediation
4) Arbitration
If those at odds do not resolve the conflict by Step 4, the Arbitration Judge determines the outcome and provides a resolution.
Who Uses a Buy-Sell Agreement?
All business entities, including C corporation, S corporation, partnerships and LLCs, use buy-sell agreements. It does not have to be a stand-alone agreement. Buy-sell provisions may be drafted to incorporate into the entity’s other organizational documents. Buy-sell provisions may exist in organizational documents and not reflect the true desires of the business. Sometimes they appear as part of a standard package of organizational documents. This could be detrimental to the succession plan. An attorney may need to amend or override such documents by creating a stand-alone buy-sell agreement. This customization may likely be needed to properly implement the family’s business succession plan.
Why Should a Family Business Owner Do a Buy-Sell Agreement?
A buy-sell agreement provides for stability and continuity in the family business. The agreement may prohibit the transfer of ownership to unwanted third parties. It provides a way to determine the sale price for the shares and how the purchase will be funded. The agreement typically provides a way for the business owner to maintain control of the business. This control balanced with a clear plan for transition to the owner’s chosen successors provides peace of mind for all involved.
How Should the Owner Structure the Buy-Sell Agreement?
Structuring a buy-sell agreement allows a noninvasive forum for an owner to think through important questions in advance:
1) Who should run the business?
2) Which family members will be included in the business?
3) What do I leave family members who are not involved in the business?
Typically, the business owner will only want those children who are active in the business to manage the business. They may use proceeds from the sale of the business to provide for children not involved in the business. By carrying out the owner’s intent, a properly structured buy-sell agreement avoids the inevitable disputes among heirs who are active and want to invest in the business and those who are not active in the business and just want cash.
Continued Cash Flow for the Owner
A buy-sell can provide owner with knowledge that cash flow may continue. The Agreement can provide for the business to purchase owner’s interest in the business at a predetermined price. Sometimes the business uses proceeds to purchase disability insurance to provide cash flow should an owner become disabled.
Keep the Business in the Family
A buy-sell agreement can help keep the business in the family and ensure smooth transition to the next generation:
1) Provide an illiquid asset avoiding a “fire sale” because the sale price is determined by the Agreement
2) Provides liquidity to pay any estate taxes
3) Provides for a surviving spouse
4) Under certain circumstances, fixes the value of the shares for federal estate tax purposes.
Type of Buy-Sell Agreement
There are three different types of buy-sell agreements:
- Cross Purchase
- Redemption
- Combination
In a cross-purchase agreement, the remaining shareholders are required to buy, or given a right of first refusal over, the shares of the deceased or withdrawing shareholder. In contrast,
a redemption agreement is where the business itself that is required or given an option to buy the shares. In a hybrid agreement, the business typically has the first opportunity to purchase the shares, with any shares not purchased by the business required (or given the option) to be purchased by the other shareholders.
How do you fund the buy-sell agreement?
Proper funding of a buy-sell agreement may include:
1) Life insurance
2) An installment note
3) A sinking fund
4) Some combination of the first three alternatives.
Life Insurance
Life insurance works well to fund the Agreement. It provides purchasers with the ability to guarantee a certain amount of money at the death of the owner. Family businesses may purchase some form of permanent insurance. This gets more expensive as the insured ages and may not be renewable beyond a certain age. If the business cannot afford permanent cash value type of insurance, a convertible term insurance policy works as an alternative.
Life insurance requires the purchasing of a policy on each shareholder in a cross-purchase agreement if there are more than two shareholders. This can be overcome if a partnership is established to own the insurance or a Life Insurance, LLC, is formed. If a C corporation uses life insurance to fund a redemption agreement, 75 percent of the life insurance proceeds will be subject to the corporate alternative minimum tax if the corporation has gross receipts in excess of $7.5M.
Installment Note
The next funding alternative is to fund the purchase using an installment note that qualifies for capital gain tax deferral under IRC Section 453. An installment note is sometimes used in lieu of life insurance funding. The business owner must choose a term (usually 10 to 20 years). They must also choose a reasonable interest rate or the applicable federal rate as set forth in IRC Section 1274(d).
In the family business context, the applicable federal rate should be the floor for the interest rate as it guarantees the IRS will not recharacterize a portion of the loan as a taxable gift. The buy-sell agreement will generally require the purchaser to pledge the purchased shares as collateral until the loan is completely paid.
Sinking Fund
The third option is the least common way to fund a buy-sell agreement, which is through the creation of a sinking fund accumulated over time for the purpose of funding the buyout.
In order for a buy-sell agreement to be successful, its terms should be coordinated with the rest of the owner’s estate plan. If the provisions of the business owner’s will conflict with the buy-sell agreement, it’s problematic.
Important issues to consider include:
1) The choice of the fiduciaries
2) How should the estate tax be apportioned
3) How will the terms of the buy-sell agreement impact the ability of the estate to take advantage of certain post-mortem planning opportunities
4) Each party should obtain legal counsel if desired or sign waivers
Integrating with Advisors
Building an effective Buy Sell requires a team approach from the advisory team. This might include:
- A lawyer should prepare the Agreement. If the lawyer is acting for one of the parties and not the company, the parties would be well advised to have separate legal counsel.
- An insurance professional to provide Life Insurance, Disability Insurance and other appropriate insurance products as needed.
- A CPA or tax professional to advise on how cash flows are used to pay insurance premiums and the resulting tax consequences to the parties.
- CPA may assist in business valuation
- An appraisal done by a qualified valuation expert is often necessary.
- Each party will need their own separate estate planning.
- A money manager or investment advisor may address the effective deployment of the company’s cash flow reserves.
- Business succession consultant to help groom the business for sale to a third party or to the parties involved in the buy sell arrangement.
Buy-sell agreements remain a significant document in most business succession plans for family businesses. A properly structured buy-sell agreement:
1) Makes sure that the business passes to the intended beneficiaries
2) Minimizes the possibility of fighting among family members
3) Creates a market for the asset.