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Do I Need a Buy-Sell Agreement?

July 22, 2013

Buy-sell agreements, cross purchase agreements, shareholder agreements and stock redemption agreements are the various forms and names of agreements between business owners ("Agreements") which are used to provide for the orderly transfer of closely held business interests. They differ only in respect of the manner in which the purchase is accomplished and the purchaser. The purpose of this article is to highlight some of the reasons business owners should consider such Agreements an integral part of their business operation (for the purposes of this discussion, all will be called buy-sell agreements unless otherwise specifically identified). Also, while the focus may be corporate buy-sell agreements, most of the concepts apply equally to partnerships and limited liability companies, with the exception of those income tax issues which effect only corporations or partnerships. For this reason, rather than referring to stock or shares or partnership or membership interests, the term "business interest" is used throughout most of this outline unless the discussion pertains only to stock or to partnership/LLC interests. Subsequent additions to this series will address income and estate tax issues as well as valuation issues and funding.

Practical Business Reasons for Buy-Sell Agreements

Planning is essential in any business in which there is more than one owner. The earlier that a plan for the transfer of ownership is established and memorialized, the greater the likelihood that conflict will be avoided or eliminated when the time for the transfer of ownership occurs. As I am sure you are all aware, it is easier for the parties to reach agreement on key business terms at the being of the business relationship, when everyone has positive feelings for each other, than at the time things are deteriorating and in an adversarial posture. It is imperative for any multiple owner business to pre-arrange the disposition of the respective shares of the business to address the common events of death, retirement, disability, bankruptcy, divorce, or the situation where an owner's employment is terminated voluntarily or involuntarily. The failure to address these issues at the beginning of the business relationship can lead to expensive and time consuming legal battles, not to mention the emotional stress.

A buy-sell agreement is a written agreement between the owners of a business which states what will happen in the event of death, retirement, disability, termination of employment, bankruptcy, divorce, disputes between the owners as to how to operate the business, third party purchase offers, and/or withdrawal from the business. The agreement can also serve to restrict who may become an owner of the business. Since the purchase of the business interest is a key feature of any buy-sell agreement, the method for determining the purchase price is important. There are a number of different methods for valuing the business which will be discussed in subsequent posts. The buy-sell agreement can also help to set the value of the business interest for estate tax purposes.

Among those situations that can be resolved by a buy-sell agreement are: (1) purchases from a disgruntled/disruptive/ineffective owner; (2) provide liquidity in the case of a deceased owner; (3) keep the business "in the family" by restricting sales to outside parties; (4) eliminate disputes about purchase price and purchasers upon death or retirement.

In selecting the type of buy-sell agreement the identity of the purchaser of the business interest must be determined. In the case of an entity purchase agreement, a corporation, limited liability company ("LLC") or partnership redeems or purchases the business interest. In a cross-purchase agreement the individuals are the purchasers of the business interest. The major drawback to an entity purchase arrangement is the loss of basis for the continuing owners. This occurs because while the entity pays the market value for the business interest ('the initial purchase"), the continuing owners have the same tax basis in the interests they own, though in percentage terms they own more of the entity. Consequently, when it comes time to sell their interests they will pay more tax because they will realize more gain on the sale. The money paid by the entity at the initial purchase does not increase the tax basis of the remaining owners in the interests they own, those interests retain their historic tax basis, subject to certain adjustments in the case of S-corporations, partnerships and LLCs. If a cross purchase agreement is used, the purchasing owners are responsible for the payment of the purchase price and get a cost basis in the interests that they purchase. Accordingly, there is no loss of tax basis as with an entity purchase

In some situations the buy-sell agreement is in the form of a "wait and see" agreement. Rather than requiring either the entity or the owners to purchase the business interest, the agreement gives the individuals the option to purchase and, in the event that it is not exercised, the entity is required to purchase the business interest. The entity is the one with the ultimate obligation to purchase so that, in the case of a corporation, the redemption by the corporation is not treated as a dividend distribution with respect to the shareholders. If the shareholders had the binding obligation to purchase, but did not, and the corporation redeems the stock, there is the potential that the redemption would be treated as fulfilling the shareholder's obligation, generating an adverse income tax consequence for the shareholder.

A consideration for all buy-sell agreements is how to fund the purchase price. Basically, the funding mechanism will be the cash flow generated by the business, whether the business is going to be the purchaser and retains earnings to fund the purchase obligation or distributes additional cash to its owners so they can build up the necessary reserves. A variation on this concept is having the entity or the owners purchase life and/or disability insurance to help fund the purchase obligation. This can present certain problems when one or more of the owners are uninsurable or insurable only at a high premium payment. Also, dependent upon who is paying the premiums on the policies, disparities in age can greatly increase to relative costs to each owner and the resulting financial burden on the payor. An additional issue with a cross purchase agreement is when there are multiple owners and the agreement is funded with life insurance. The number of insurance policies required is determined by the formula X=n (n-1) where "n" is the number of owners. If there were four shareholder/owners you would need a total of 12 life insurance policies to cover each potential purchase obligation. Another factor to consider, when the entity has the obligation to redeem or repurchase the ownership interest, state law requirements, as well as financing agreements with banks and other creditors, may well limited the distributions that can be made to owners and this restrict the purchase price and/or impact the planned payment schedule.

A buy-sell agreement can also be used to help resolve the issue of succession of ownership in the case of the family business. This can be accomplished by giving the individuals that will be active in the business the right to purchase the business interests from the estate of a deceased owner and have the proceeds of that purchase distributed to the heirs that are not active in the business. A potential problem for any closely held business is the conflict between owners/shareholders that are active in the business, and earning a salary, and those that are not active in the business and not receiving a salary. For the second group, they are dependent upon distributions from the entity, or the sale of their ownership interests, for cash flow. Avoiding this problem with a carefully drafted buy-sell agreement can be of significant value to the business and its owners.