A buy-sell agreement is a legal contract commonly used by an owner of an interest in a closely held business to transfer his or her ownership interest to his or her successors. It is an agreement that you can enter into now to provide for the future sale of your business interest. Under the terms of a buy-sell agreement, the buyer is legally obligated to buy your interest in the business from your estate, and your estate is legally obligated to sell your business interest at your death. A buy-sell agreement has many advantages, including the following:
Technical Note: A buy-sell agreement is also referred to as a business continuation agreement or a buyout agreement.
What are the advantages of a buy-sell agreement?
Provides liquidity for the payment of expenses and taxes (but only if the agreement is funded)
Generally, federal estate taxes are due within nine months after your death. In some states, state death taxes are due even sooner than that. If your estate owes taxes, your personal representative will need enough cash to pay them. Unless liquid assets are otherwise available, you may want to be sure that your personal representative will be able to convert your portion of the business into cash quickly and at a fair price. Under a buy-sell agreement, the sale of the business interest can occur quickly and your family can be spared the worry of how to pay the estate taxes.
Caution: If the buyer does not have the cash or access to cash when it’s needed for the buyout, the agreement will fail to provide the needed liquidity. Therefore, make sure the agreement specifies a plan to fund the buy-sell agreement and, more importantly, that the funding takes place.
Provides for the continuation of the business
Certain forms of business organizations end at the death of an owner. A buy-sell agreement can prevent the termination of your business at your death. The following table lists some of the common business forms and what would happen at your death without a buy-sell agreement in place:
|What Happens When an Owner Dies?|
|Business Form||Law Says|
|Sole Proprietor||The business enterprise terminates. Its employees have no authority to continue operations. A personal representative can continue the business but it is not allowed to benefit from any activities needed to continue the business, and may be personally liable to estate beneficiaries for any losses incurred during continuation.|
|Partnership||The partnership dissolves. The partnership may wind-up and liquidate, or the surviving partners may continue the business as a new partnership.|
|Professional Corporation||Many states limit ownership to members of same profession, meaning heirs or a personal representative could not assume ownership of stock.|
|Corporation||The business entity does not terminate, but is generally disrupted by loss.|
Avoids the need to sell the business at an unfairly low price
When you die with a buy-sell agreement in place, your estate does not have to search for someone who is willing to buy your share of the business. Your estate will not be forced to sell your business interest at an unfairly low price to get the cash needed to pay for expenses and taxes when they are due. The buy-sell agreement spells out exactly who will buy your interest in the business, under what circumstances, and at what price.
Caution: For this to work, you must fund the buy-sell agreement.
Avoids potential conflicts of interest between surviving owners (if any) and your heirs or beneficiaries
At your death, there may be a conflict of interest between your surviving co-owners (if any) and your heirs or beneficiaries. Generally, it is in your beneficiaries’ best interest to receive the largest amount of cash possible from the business. Likewise, it is generally in the surviving co-owners’ best interest to continue the business operations without interruption and keep liquidation costs to a minimum. With no prearranged agreement, the differing needs of your beneficiaries and your surviving co-owners are likely to result in a dispute. A buy-sell agreement can ensure that your plans for your business interest and your beneficiaries are carried out as you intend.
Can establish the value of the business for estate tax purposes if structured properly
Under the right circumstances, the buy-sell agreement may set the fair market value (FMV) of an interest in the business when the agreement is executed. When the agreement is structured properly, the IRS will accept the taxable value as fair market value if certain conditions are met.
Caution: Buy-sell agreements between family members or related parties can be subject to close scrutiny by the IRS. The definition of family member includes your spouse, both your parents and your spouse’s, plus the lineal descendents of your spouse and parents, and their spouses, and any other “natural objects of the transferor’s bounty.”
Maintains stability of business operations
The buy-sell agreement specifies exactly who will continue as owners of the business. The agreement can be used to ensure that the people who have been running the business can continue to do so and that the surviving co-owners will not be forced to accept outsiders into the business.
Improves creditworthiness of the business
A buy-sell agreement increases the probability of the business continuing successfully after your death. The continued existence of the business means the continued ability to meet outstanding loan payments. Creditors may view the business as more stable, may see the owners as responsible businesspeople, and may be more likely to extend credit to the business.
Maintains legal status of your S corporation, partnership, or professional corporation (if relevant)
A buy-sell agreement can protect S corporation status by preventing ineligible shareholders from holding shares of the corporation, preventing ownership by more than the maximum allowable number of shareholders, and by complying with the one class of stock requirement. It can protect partnership status by avoiding liquidation at the death of a partner, provided that the other partners agree to allow the purchaser to buy-in to the partnership. In most states, nonprofessionals are not allowed to be stockholders in a professional corporation. Use of a buy-sell agreement can prevent a nonprofessional from becoming a stockholder in your business in violation of the law.
Are there any tradeoffs?
Restrictions can affect personal estate planning
Gifting strategies are important estate planning tools for owners of closely held businesses. Lifetime gifts of your interest in the business could be part of your estate plan to pass your business interest to your beneficiaries and reduce the total value of your estate. Restrictions in the buy-sell agreement could prevent you (and your co-owners) from gifting all or part of your interest in the business. The parties to the agreement therefore must consider whether to restrict transfers by gift.
Tip: If the ownership group decides to allow gift transfers, the group of permissible donees should be defined.
Restrictions could limit your access to outside credit
Restrictions within the buy-sell agreement could prohibit you from pledging your own interest in the business as collateral for outside credit or could require the consent of the other owners. If you are unable to pledge your business interest, a lender might turn you down for a loan.
Restrictions may be unenforceable under state law
State property laws favor the right of a business owner to transfer an interest in a business whenever and to whomever he or she wants, and at whatever terms he or she wants. Generally, restrictions in a buy-sell agreement that are extreme will be viewed as unreasonable and therefore unenforceable. For instance, a restriction that may be viewed as extremely prohibitive and therefore is one that permanently and absolutely bans lifetime transfers of shares of a business’s stock, along with a mandatory resale of the shares to the corporation at death for the original purchase price. A restriction like this could be viewed as a forfeiture, unreasonable, and therefore unenforceable. On the other hand, if the only condition for a profitable transfer of stock is a pure right of first refusal that requires the offer of the stock to the holder at the right price offered to other parties, the restriction is not extremely prohibitive and would almost always be enforceable.
In general, if the terms of the restrictions were reasonable when the agreement was executed, such as rights of first refusal and rights to buy interests in the business based on a formula set price, the restrictions would be enforceable. Whenever a buy-sell agreement is ambiguous, the courts will not uphold the enforceability of the restrictions. However, a carefully drafted, clearly outlined buy-sell agreement containing reasonable terms of restriction should be able to avoid any issues with state law.
How do you implement a buy-sell?
Get help from a professional
Setting up a buy-sell agreement can be very complex because it involves many legal and tax issues. Get help from an attorney experienced in contracts, a tax advisor, and a financial planner.
Tip: Each party to the agreement should have his or her own attorney and advisors.
Decide what type of buy-sell is best for you
A buy-sell agreement can be a powerful tool in a business continuation plan. When coordinated with your other estate and tax planning, a buy-sell agreement can provide a smooth transfer of your ownership interest. Besides looking at your own personal goals, you should consider factors specific to your business before you decide on a particular type of buy-sell agreement. For instance, the number of owners in your business may make some types of buy-sell agreements cumbersome or even impossible.
Execute a buy-sell agreement
Put the agreement in writing. Execute a formal, legal document. Be sure to state the purchase price, terms, and funding arrangements in the document.
Periodically review the agreement
When you have drafted your buy-sell agreement, don’t just put it away and forget about it. You and your buy-sell participants should review the agreement on a regular basis, perhaps yearly. You’ll want to be sure that the agreement still meets your objectives. Also, the valuation provisions may require an annual valuation of the business.