If you own an interest in a family-owned or other closely held business, a buy-sell agreement is a valuable document to have in place. These agreements specify whether — and under what circumstances — owners’ interests may be transferred. Buy-sell agreements should be planned and drafted carefully to ensure that they meet your expectations and don’t trigger unwanted tax consequences or conflicts with other owners or family members.
Consider the benefits
A well-crafted buy-sell agreement provides many benefits, including:
- Keeping ownership of the business within the family or another select group (for example, people actively involved in the enterprise),
- Preventing an owner’s former spouse from acquiring a business interest in the event of a divorce,
- Providing owners and their heirs with liquidity to pay estate taxes and other expenses in the event of death or disability,
- Establishing the value of the business for gift and estate tax purposes (if certain requirements are met), and
- Minimizing disputes over ownership succession issues.
Typically, buy-sell agreements achieve these objectives by requiring or permitting the company or the remaining owners to purchase the interest of an owner who dies, becomes disabled or leaves the business. They may also provide the company or the remaining owners with a right of first refusal in the event an owner wishes to sell his or her interest.
Beware the tax implications
Generally, buy-sell agreements are structured either as “redemption” agreements or “cross-purchase” agreements. The former permit or require the company to purchase a departing owner’s shares, while the latter confer that right or obligation on the remaining owners.
From a tax perspective, cross-purchase agreements are generally preferable. The remaining owners receive the equivalent of a “stepped-up basis” in the purchased shares, in that their basis for those shares will be determined by the price paid, which is the current fair market value. Having the higher basis will reduce their capital gains if they sell their interests down the road. Also, if the remaining owners fund the purchase with life insurance, the insurance proceeds are generally tax-free.
Redemption agreements, on the other hand, may trigger a variety of unwanted tax consequences.
The disadvantage of a cross-purchase agreement is that the owners, rather than the company, are responsible for funding the purchase of a departing owner’s interest. And if they use life insurance as a funding source, each owner will need to maintain insurance policies on the life of each of the other shareholders, a potentially cumbersome and expensive arrangement.
Set a fair price
A buy-sell agreement’s valuation provision is critical to avoiding unpleasant surprises or conflicts. Generally, the fairest and most effective method of setting the purchase price is to conduct periodic independent business valuations and to base the price on fair market value.
Many agreements set the price using a formula tied to earnings, cash flow, book value or some other objective measure. Although formulas offer simplicity and lower costs, they can’t account for subjective characteristics or other factors that drive business value. As a result, they often underestimate or overestimate business value, which can lead to disputes when the buy-sell agreement is invoked.
Buy-sell vs. shareholders’ agreement
The terms “buy-sell agreement” and “shareholders’ agreement” are often used interchangeably. But in fact, a shareholders’ agreement refers to a broader category of which a buy-sell agreement is a subset.
A buy-sell agreement deals specifically with the disposition of shares of a shareholder who dies, becomes disabled, or wishes to sell his or her ownership interest. Shareholders’ agreements typically include buy-sell provisions, but may also include noncompetition, nonsolicitation and confidentiality restrictions; voting procedures; dispute resolution mechanisms; and other provisions related to corporate governance or shareholder relations.
Choose your words carefully
Before signing a buy-sell agreement, test it to see how it’ll perform under various scenarios and choose your words carefully to ensure that it fulfills your objectives. Consult your tax advisor and your attorney for assistance.