A well-drafted buy/sell agreement can be the difference between the proper inheritance of your business and costly court interventions. It lays out what should happen to your (and your partner’s) share of ownership in the business should you pass away, become incapacitated, get divorced, file for bankruptcy, or leave the business in some other way to maintain business continuity.
As a result, buy/sell agreements are an essential part of estate planning for business owners, management partners, and significant stakeholders. Our business succession planning attorneys can provide you with the guidance that you need throughout this process.
The Two Types of Buy/Sell Agreements
There are two principal types of buy/sell agreements, each with its own benefits: a cross-purchase agreement and a redemption agreement.
- A cross-purchase agreement allows theremaining owners of the business to buy back the deceased’s or otherwise divergedshare.
- A redemption agreement requires the businessentity to buy back that same ownership share. There is no option to buy but anobligation bestowed on the business.
A combination of these two is known as a “wait-and-see agreement,” in which the type of buy/sell agreement is determined at the time when one such owner passes away or leaves the business instead of earlier or at the business’s inception.
These agreements can either be found in your operating (in the case of an LLC) or shareholder (in the case of a corporation) agreement, or you can draft them separately.
Tax Implication of Both Agreements
Since a buy/sell agreement is one of the estate planning terms you may hear, it’s important that you know about the details of one. A cross-purchase agreement aims to reduce long-term capital gains tax on selling the remaining owners’ future shares. And should the remaining owners use life insurance to buy back the deceased owner’s shares, these proceeds will usually be tax-free.
However, the disadvantage is that the burden of the buyback is placed on the remaining owners instead of the business entity itself, no matter how the business is structured. And should the remaining owners leverage life insurance for the buyback, the owners must all maintain life insurance policies on each other–an expensive endeavor.
Redemption agreements are generally less favorable in the realm of tax savings. They can trigger a variety of unwanted tax burdens, including corporate alternative minimum tax and even the treatment of the sale as a taxable dividend.
What should be included in a buy/sell agreement?
It’s recommended that you work with a knowledgeable attorney to spell out what should and shouldn’t be included in your buy/sell agreement.
Here are some typical components of a buy/sell agreement:
- A list of events that trigger the buyback, such as death.
- A list of the remaining partners responsible for the buyback.
- A description of how those partners plan to fund the buyback; and
- An up-to-date valuation of the company.
Ensuring that your business is correctly valued at the time of the triggering event is equally as important as spelling out your buy/sell agreement unequivocally.
How is the business valued at the time of the buyback?
Stating precisely how your business should be valued at the time of the triggering event is imperative to determine the correct amounts at all stages of the buyback.
A lacking or nonexistent business valuation method may lead to unwanted financial disputes among the remaining businessowners and other beneficiaries as conflicts around calculation methods may arise.
One of the fairest ways to go about properly valuing your business is to do so periodically and independently; in other words, to conduct independent valuations of your business at a reasonable market price on a recurring schedule (say, quarterly) so that you almost always have a current valuation of your business.
It’s also advisable to work with financial professionals who help you pin down accurate valuations at the right time.