Anyone who has ever watched a relay race or a football game knows that a lot can go wrong during a handoff. The same is true when control of a business is being passed from one person to the next.
Indeed, the death, disability or retirement of a major shareholder in a closely-held family business can be a time of great upheaval and uncertainty. If not handled properly, the event could lead to the unnecessary liquidation of the business or the sale to an unrelated third party. Providing a mechanism for handling these shareholder transitions is critical to the long-term success of a family business.
Fortunately, among the estate planner's tools is something called a buy-sell agreement, which provides for the mandatory purchase (or right of first refusal) of a shareholder's interest, either by the other shareholders or by the business itself, upon the occurrence of certain events described in the agreement.
Buy-sell agreements are appropriate for C corporations, S corporations, partnerships and limited liability companies, and it is not necessary to have a stand-alone agreement, since buy-sell provisions can be incorporated into the entity's other organizational documents. Here are seven things you need to know about buy-sell agreements.
Reasons for Establishing a Buy-Sell Agreement
The purpose is to provide for the stability and continuity of the business in a time of transition through the use of ownership transfer restrictions. Typically, the agreement prohibits the transfer of ownership to unwanted third parties by stipulating how, and to whom, shares may be transferred. The agreement also provides a mechanism for determining the sale price and how the purchase will be funded. For a retiring or disabled shareholder, the agreement can provide for the corporation and/or other shareholders to purchase his or her shares, either in a lump sum or installments, at favorable capital gains rates. For family members of a deceased shareholder, a buy-sell agreement avoids a fire sale because the sale price is determined by the agreement, provides liquidity to pay any estate taxes and, under certain circumstances, can fix the share's value for estate tax purposes. For the remaining owners, the agreement avoids having to deal with going into business with a deceased shareholder's spouse or children.
Structuring the Terms
Obviously, each family business is unique; what works well for one family business could be a disaster for another. A buy-sell agreement has to be tailored to the particular circumstances, taking into consideration such factors as the type and size of the business, its value, relationships among family members, how purchases should be funded and which family members and their spouses may be allowed to be shareholders.
Types of Buy-Sell Agreements
There are three different types: A cross-purchase agreement, a redemption agreement and a hybrid agreement. In a cross-purchase agreement, the remaining shareholders are required to buy, or are given a right of first refusal over, the shares of the deceased or withdrawing shareholder. In a redemption agreement, it is the business itself that is required or given an option to buy the shares. In a hybrid agreement the business is typically the purchaser. Any shares that are not purchased by the business are required to be purchased by, or optioned to, the remaining shareholders.
Choosing Among the Three Types
In choosing among the three alternatives, the key decision to be made is who will be the purchaser. If the purchase of shares will be funded with life insurance and there are multiple shareholders, a cross-purchase agreement may not be appropriate. The reason for this is that (unless a partnership is used to own the insurance), a cross-purchase agreement requires each shareholder to own a policy on every other shareholder.
For example, if there were four shareholders, there would need to be 12 policies. Six shareholders would require 30 policies. With a redemption agreement, there would only need to be one policy on each shareholder. In recent years, the hybrid agreement has been gaining in popularity because it is more flexible than the other two alternatives.
Setting the Purchase Price
Perhaps the most important thing that a buy-sell agreement does is to set the purchase price for an otherwise illiquid asset. The price is determined at a time when each owner is negotiating from a position of strength since none of them knows to whom the terms of the agreement will apply to first. There are several ways in which the agreement can set the purchase price.
One common way to set the price is by the periodic agreement of the owners. The main concern here is that the owners fail to meet regularly and, therefore, the price does not reflect current values. A second approach is to set the purchase price by a formula which takes into consideration such factors as book value and multiples of earnings. (Use a valuation expert if a formula clause is used.)
Fixing Value for Estate and Gift Tax Purposes
Buy-sell agreements, established or substantially modified after Oct. 8, 1990, are subject to Internal Revenue Code section 2703. Section 2703 was enacted to prevent buy-sell agreements from being used as an artificial mechanism for passing business assets to family members for less than fair market value. Section 2703 disregards any restrictions imposed by a buy-sell agreement unless the agreement meets all of the following requirements: (a) it is a bona fide business arrangement; (b) which is not a device for transferring property to family members for less than fair market value; and (c) its terms are comparable to similar arrangements entered into by persons in arms'-length transactions. The strict rules of section 2703 do not apply to entities where more than 50 percent of the value of the property subject to the right of restriction is owned by individuals who are not members of the transferor's family. It is important to note that even if the requirements of section 2703 are satisfied, it only means that the IRS will take the restrictions into consideration when figuring out the transfer tax value. The price in the agreement must also meet several common tests set forth in case law before it will be determined to fix value for estate and gift tax purposes.
Funding the Buy-Sell Agreement
One of the most common ways to fund a buy-sell agreement is with life insurance. Choosing the right kind of policy (term, whole life or some variation) depends upon the particular circumstances. Other ways to fund the buyout include a payout from corporate earnings or the use of an installment note.
A buy-sell agreement is an important component of a business owner's estate plan, but unless it is properly drafted and tailored to the particular circumstances, it can do more harm than good. It is important to realize that even in the happiest of family businesses, the interests of particular family members may be divergent. Therefore, each family member should consider obtaining his or her own legal counsel to ensure that the buy-sell is as fair as possible.