Many businesses with multiple partners do not have a Buy-Sell agreement. This could cause major problems should something happen to a partner. These agreements are contracts between business owners for the purchase and sale of the shares of a business or professional practice in the event of death, disability or retirement. The last thing your partners want is to be in business with your spouse, heirs or your executor.
A properly drawn buy-sell agreement will establish a pricing methodology for the business, serve to have a ready buyer for the company stock, and may be used to value the business interest for federal estate tax purposes. All businesses with more than one partner (except husband and wife) should have a buy-sell agreement that addresses both death and disability. Both of these issues are of equal importance and require attention.
The disability buy-sell is a bit more complex to construct because of the various gray areas around the question of what does disabled mean. In addition, the following questions must be answered:
At what point during a disability will the buy-sell occur? And..How will the funding mechanism work? (Installments or lump sum) and most importantly where would the money come from?
Once these two variables have been determined, the disability and life buy-sell language should be similar.
It is important to value the business properly in order for the price to establish the decedent’s value for federal estate tax purposes. Generally, IRS revenue code 2703 requires that the following three items be used when developing the price for estate tax purposes:
The agreement must be a bona fide business arrangement - in writing and executed by all parties
The transfer must be for full and adequate consideration (a sale for less than fair market value could be viewed as part sale, part gift.
The agreement must be at arm’s length (as if you were selling to a third party buyer).
Because business values change, it is impossible to know what the business will be worth at some future date and time. Thus, when valuing the business, it is recommended that a pricing formula be used and not a fixed dollar amount.
There are two types of Buy-Sell agreements: Stock redemption and cross purchase. Each has very different tax consequences. As an example: In a stock redemption agreement, the company purchases the stock from the disabled/deceased shareholder the shares effectively no longer exist which in turn increases the value of the remaining shareholders. A stock redemption agreement DOES NOT increase everyone else's cost basis. A cross purchase agreement does increase the cost basis on the newly acquired shares. The only problem is that if there a large number of shareholders, each one must enter into the same agreement - more paperwork.
How to fund your buy sell plan
Where will the company or partners get the cash to buy the stock? These can be funded with insurance, bank loan or current profits. Most partners/companies choose to use insurance for the funding mechanism because of low cost and flexibility (if everyone is insurable). For example, when considering funding the disability provision of a buy-sell agreement, a disability buy-sell policy will allow for lump sum funding. Without this policy, a bank loan would probably have to be obtained to buy out the disabled owner’s interest.
Since a business interest could comprise the majority or large portion of a partner's net worth, it is critical that estate planning be done at the same time. Questions like the following must be answered: Who should get the cash? Should the money be held in trust to protect against lawsuits, remarriage, future divorces, heirs' level of financial sophistication? This list goes on. These are just a few considerations. Why leave to chance what can be accomplished through calculation? For more information, contact a qualified attorney or David Disraeli at 512-464-1110. Or book a call