Some Notes on Buy-Sell Agreements
1. Why is it important to have a discussion about buy-sell agreements in the context of estate planning?
The ownership interest in a closely held business represents a substantial portion of an individual’s wealth. Determining how much his or her family will be paid for that interest and when payment will occur is a very important part of the estate plan. If the value is trapped in the business or can only be extracted over a long period of time, that changes how the surviving spouse and family can expect to enjoy the transmission of wealth.
2. Do most closely held businesses have buy-sell agreements?
Yes, but many of them have not been properly updated and do not reflect changes in value and ownership. Other buy-sell agreements don’t cover what happens in all cases, and might contain provisions that are actually destructive to the survival of the business.
3. Is there a single format for buy-sell agreements?
No, but there are certain matters that could be addressed:
- voting of shares to elect directors
- agreement by shareholder directors as to management of business
- transfer of ownership to family members
- transfer of ownership on death of owner
- transfer of ownership at other events: disability, termination of employment, bankruptcy, divorce
4. How is ownership valued in a buy-sell agreement?
There are several ways of valuing the ownership in a closely held business:
- Hire a professional valuation expert. You might decide to do this only every few years; and have a formula to reflect changes in value in the interim.
- There can be a formula in the buy-sell agreement for determining value. An accountant or other valuation expert could assist in determining an appropriate formula.
- The owners can decide for themselves what the correct valuation should be. But they need to understand that if they choose a “bargain” price, that’s what is paid to the family of a deceased owner.
5. How is the purchase price for the ownership interest paid?
The purchase price can be paid soon after the sale event or in installments. The method is usually governed by whether funds are available for the purchase. The most frequently used method for obtaining the necessary funds is life insurance on the other owners; or the corporation could own insurance of each shareholder: a cross-purchase or a corporate redemption.
6. What are the problems with using life insurance?
You need to decide how much coverage you want, and that might change over time. But the insurability of the owners might differ even at the outset, and might change in different ways over time. It is important to have the right kind of insurance, and for that you need an insurance consultant.
7. What else does a buy-sell agreement cover?
If a third party offers to buy the interest of one of the owners, the agreement will generally require that the interest be offered at the same price and terms to the other owners, and can be sold to the third party only if the other owners do not buy it. Alternatively, the agreement could provide that the ownership may not be sold to outsiders. Or that if an outsider wants to buy out one owner, the offer must extend to all owners. Or that if an owner receives an offer, the other owners must match it or agree that their interests will be sold on the same terms to the outsider.
8. Will the IRS accept the valuation of ownership interests for estate tax purposes?
Not if it is a testamentary plan, such as a parent entering into an agreement with children. The agreement must approximate fair market value, bind all parties during life and at death, and be a bona fide arms’ length business arrangement. The IRS has considerable experience in reviewing agreements and attacking those trying to avoid fair market valuations.
9. What should business owners do?
- if they don’t have a buy-sell agreement, have one prepared
- if they already have one, have it reviewed and updated, along with the life insurance that funds it.