A Buy-Sell Agreement is an important transition and succession planning tool to help businesses manage changes in ownership due to life events such as: death, disability, retirement, and bankruptcy. It is in the best interest of a business with more than one owner to have a formal written Buy-Sell Agreement once the business reaches a certain value. Buy-Sell Agreements can take many forms and perform many functions. They may also raise significant tax, legal, and business issues that you may not have otherwise considered. This article will provide you the fundamentals of a Buy-Sell Agreement and what you need to know to protect yourself.
- What is a Buy-Sell Agreement?
Buy-Sell Agreements are contracts by the owners of a business that restrict the transfer of the parties’ business interests, and thereby assure that business owners are required to share their control only with persons acceptable to them. It intends to assure the smooth future transition of business ownership and helps the owners to agree on a way to value the company in advance of a buy-sell or buyout situation.
- Why is a Buy-Sell Agreement important for a business?
A Buy-Sell Agreement becomes a standard device used by estate planners to assure an orderly succession of the ownership and management of a business after the death of an owner, to improve estate liquidity by assuring a market for a decedent’s business interest, and to establish an estate tax value for a decedent’s interest in a business.
It has the ability to protect and preserve the business from internal fights, and to assure that interests in the business do not fall into the hands of competitors or other inappropriate individuals.
During a dispute between business owners and/or their family members, it acts as a prenuptial agreement for the parties to provide a framework for dealing with such a difficult situation. And, it could mitigate the risk of entering into a litigation that can only do more harm to the business.
In the case of bankruptcy of one of the owners who owns 50% or more of the business, a bankruptcy trustee could liquidate the business and take half to pay the bankrupt owner’s debts. To prevent a business from getting tied up in bankruptcy court, the owners can sign a Buy-Sell agreement that requires a co-owner who faces bankruptcy to notify other co-owners before filing. Under the terms of this agreement, this becomes an automatic offer to sell the bankrupt owner’s interest back to the other owners or to the business.
- What are the necessary components of a Buy-Sell Agreement?
As with any contract, a Buy-Sell agreement must be structured properly to insure its effectiveness. There are many ways to structure and fund the agreement. However, there are some fundamental components that you need to be sure are included in the agreement which includes the following:
- Commitment of the parties involved and their respective obligation
- Purpose of the arrangement
- Valuation method of the business
- Funding mechanism(s) (life insurance, cash, installment payments, etc.)
- Transfer restrictions on ownership interest
- What are the different types of Buy-Sell Agreements?
Cross-Purchase. A cross-purchase agreement is a contract between or among the business owners whereby each agrees to offer to sell their interest in the entity to the other owners in certain specified situations, on terms and at a price set in the agreement. Cross-purchase agreements are normally funded with insurance proceeds. Therefore, these agreements function best when the business has only two or three owners. As the number of business owners increases, the cost of enforcing such agreement can become very high. This is due to the larger number of insurance policies required as each individual owner must carry a life insurance policy on all of the other owners.
Redemption. With a redemption agreement, the business itself would make the purchase so the owners do not individually go out–of-pocket. It is a contractual arrangement between the owners and the company. In this type of Buy-Sell Agreement, the company is obligated to redeem the shares of the deceased or disabled owner. If the stock redemption agreement is funded with life insurance or disability insurance, then the company will pay the insurance premiums. The company will own the insurance policy and the company will also be the policy’s beneficiary. The costs of the insurance premiums are then shared proportionately by all of the business owners. This is because the company is responsible for all of the insurance premium payments, not the individual owner. As such, these agreements can work effectively for businesses with more than two owners.
Hybrid agreement. Hybrid Buy-Sell Agreement provides the owners with flexibility to decide who will make the ownership interest purchase when a triggering event occurs. These agreements are typically used when there is no insurance to fund the purchase of ownership. This situation may be the best case when one or more business owners are uninsurable including an arrangement between the entity and the owners, and also between or among the owners.
- What is a good Buy-Sell Agreement?
A good Buy-Sell Agreement takes into account both estate planning and business planning concerns. The drafter must anticipate the consequences of a business owner’s death as well as those events that may prompt a lifetime transfer. Also, it is crucial to have flexible payment terms built into a Buy-Sell Agreement for business planning concerns if the agreement is not funded by insurance. This will help businesses to mitigate the significant cash flow impacts that can occur at the time of the redemption of the ownership interest.
- What are some tax considerations for a Buy-Sell Agreement?
It can be used successfully to lower estate taxes in closely held family businesses where at least one co-owner plans to leave the interest to heirs who will remain active in the business. The key is choosing a conservative price or valuation formula for the business in the buy-sell or buyout agreement to avoid unnecessary estate taxes caused by an aggressive value of the business while fulfilling the following conditions:
- The agreement must be a bona-fide business arrangement.
- The agreement must not be a device to transfer property to a decedents’ family for less than full value.
- The terms of the agreement must be similar and comparable to those entered into in an arm’s length transaction.
If the agreement is funded by life insurance for each business owner, the following tax consequences should be considered:
- Premiums used to fund the agreement are not tax deductible.
- The entire proceeds received are generally not taxable regardless of the policy’s beneficiary. However, if the proceeds are payable to certain C corporations it could generate alternative minimum tax.
- The payment of premiums made by a business in which the owner is insured is not considered taxable income.
- In a cross-purchase agreement, the cash value of the policies owned by the decedent on the other owners’ lives is considered in the decedent’s estate. However, the policies owned by the other owner on the decedent’s life are not considered in the decedent’s estate.
- No gift tax occurs upon the execution of a buy-sell agreement.
There are other tax considerations that can arise from the transactions of ownership interests between owners and between owners and the company. It is advised that you should discuss your specific situation with your tax advisor to handle the complex tax issues when these transactions take place.
- What is the financial statement impact of a Buy-Sell Agreement?
In May 2003, the Financial Accounting Standard Board (FASB) issued ASC 480, Distinguishing Liabilities from Equity (formerly known as SFAS 150 prior to the codification), which establishes standards for how a business should classify and measure certain financial instruments which have characteristics of both liabilities and equity. It requires certain instruments (e.g. mandatorily redeemable stock) to be classified as liabilities where previously such instruments were classified as equity. A redemption agreement can sometimes create mandatorily redeemable stock when it contains terms that unconditionally requires redemption by the business for cash upon the termination or death of an owner. Although this standard was deferred indefinitely for non-public companies, companies are cautioned to consider the impacts of ASC 480 and the possibility that the FASB may reinstate the application of ASC 480 with respect to non-public companies in the future.
If you would like assistance or more details on how you can benefit from a Buy-Sell Agreement and the impact it can have to your construction or real estate company, please reach out to Chavon Wilcox, CPA, CCIFP, partner in Aronson LLC’s Construction and Real Estate Group at 301.231.6288.