Anticipating the future is one of the major responsibilities of business owners. When a business is faced with uncertain questions, such as “What if we do not get the loan?” or “What if we lose our biggest account?” or “What if a co-owner dies, becomes disabled or retires?” then the owner needs to make a decision to resolve the problem.
Although the first two questions above are more complex and need more information to answer, a buy-sell agreement can provide a road map to resolve some of these problems, especially when one of the co-owners leaves the company. And, it may not be enough to draft an agreement and put it in a safe place. You need to review and revise this document periodically to keep it current.
Problems of Ownership
The primary purpose of every buy-sell agreement is to legally confer on the owners of a business the right or obligation to buy a departing owner’s interest. A well-crafted agreement can also help ensure that control of your business is protected and restricted to specified individuals, such as current owners, selected family members or key employees or managers.
Another purpose of a buy-sell agreement is to establish a price for the ownership interests. You should engage a qualified appraiser to estimate the value of those interests when making a buy-sell agreement and update the value to ensure the price keeps up with the value of the company.
Estate planning is also a priority for many buy-sell agreements. If your agreement was drafted more than a few years ago, you may need to update it based on recent gift and estate tax changes. For 2016, the top rate for the gift, estate and generation-skipping transfer (GST) taxes is 40% and the exemption limit is $5.45 million.
Common Uses for Buy-Sell Agreements
Most buy-sell agreements lie dormant for years. However, the agreement may have an impact whenever a “triggering event” occurs, such as when an owner:
- Becomes disabled; or
- Retires or voluntarily leaves the company.
You may want to make sure your agreement also covers many common triggers such as changes in an owner’s marital status. Many buy-sell agreements include a triggering event, such as conviction for committing a crime, losing a professional license or certification or becoming involved in a scandal, fraud or inappropriate behavior.
Common Forms for Buy-Sell Agreements
Buy-sell agreements are typically structured as one of the following agreements:
- Redemption, which permits or requires the business as a whole to repurchase an owner’s interest;
- Cross-Purchase, which permits or requires the remaining owners of the company to buy the interest on a typically pro rata basis; or
- Hybrid, which combines the two preceding structures and may require a departing owner to first make a sale offer to the company and, if it declines, sell to the remaining individual owners.
When choosing your buy-sell agreement’s initial structure, you should consider the tax implications. They will likely differ based on whether your company is a flow-through entity or a C corporation. And, if you are considering changing your agreement’s structure, you should weigh the time and expense of a major revision to your agreement against the risk of a potentially ineffective structure.
Sources of Funding
Buy-sell agreements require a funding source so that remaining owners can buy their former co-owner’s shares. Life insurance is probably the most common source, but there are alternatives.
If your company has liquidity and confidence in its ability to maintain it, you could rely on your reserves. However, this would leave many businesses vulnerable to an unplanned cash shortfall. Another option is to create a “sinking fund” by setting aside money for paying out the agreement over a longer period of time. Again, if your cash flow ebbs more than it flows, you may not have enough funds when they become necessary.
Drafting an initial buy-sell agreement may take a little time and a lot of thought; however, keeping it up to date should be a relatively easy task. The benefit you receive from eliminating some of the owner problems in the future may be a bigger draw and worth the effort.
For more information on buy-sell agreements, contact Tom Kosinski at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.