Sunday, September 17, 2017

Why Small Businesses Need Buy-Sell Agreements

One of the agreements that comes up time over time in my practice is a buy-sell agreement.  These are contracts between shareholders of a corporation, partners of a partnership or members of a limited liability company and the business entity itself (although, as you will see, this is optional).  The buy-sell agreements ensure that the business interest of either deceased, disabled or departing owner is transferred to the entity or the co-owner(s) according to the predetermined and agreed upon guidelines.

Why Do You Need a Buy-Sell Agreement

In the absence of a buy-sell agreement in the case of death, the decedent's business interest will pass by the terms of his or her will or the laws of intestacy. This means that the remaining owner could become business partners with people who have little or no interest in running the business or the necessary skills to do so.  Alternatively, the heirs could sell the decedent's interest in the company to an unknown outside buyer who may not unfriendly to the remaining owner.  A buy-sell ensures business continuity while providing the needed cash to the deceased partner's family to handle estate tax and funeral expenses.

A buy-sell agreement can also resolve issues surrounding a business owner's disability.  Imagine a business owner who is critical to the business' operations but becomes disabled.  This could potentially be devastating for the business.  The remaining owner would be left alone to handle business operations while trying to figure out for how long to pay the disabled partner and from what source.  The disabled partner may want to be bought out, or his or her spouse and children may want to step in to run the business instead.  The disability buy-sell addresses the issue of the purchase of the disabled owner's interest, continued salary payments and management continuity.

Buy-sell agreements are also used in the cases of:
  • termination for cause (such as when the owner stops performing his or her duties or becomes convicted of a crime)
  • personal bankruptcy 
  • divorce
  • voluntary retirement
  • loss of professional license.
Funding Buy-Sell Agreements

There are four different ways to fund a buy-sell.

One way is to put aside cash from earnings and create a savings plan, often referred to as the sinking fund.  The danger here is that the fund could get diverted to pay for urgent business-related expenses, leaving the buy-sell underfunded.

Another way is to borrow the money.  However, not all businesses can obtain good terms on a loan.  Also, loan repayment would decrease the company's cash flow and impact credit availability.

The third way is to pay the buyout price over an installment period that is agreed to ahead of time in the buy-sell agreement.  Here, it is the departing owner who faces most of the risk.  He or she risks not getting the full buyout price if the business fails, since the ability to grow the business is now in the hands of the remaining partner(s).

The fourth and final way is to buy life or disability insurance on the lives of the owners.  A permanent insurance policy can also be used for retirement buyouts. However, insurance is not available for all types of buyout scenarios outlined above.  So, some combination of the payment methods is needed to fund a  comprehensive buy-sell agreement.

Entity or Cross-Purchase Buy-Sell

One last thing that I'd like to mention is that sometimes it makes more sense for the owners to buy insurance on each other (a cross-purchase arrangement) than for the company to do so (stock redemption).  In such cases, the company itself is not a party to the agreement.  Each individual partner is the owner, beneficiary and premium payor of the policy on the life of the co-owner.  This may make sense from the tax planning perspective.  I am not a tax specialist, so I encourage to consult with one about this.

If, for example, there are two owners, each of whom has invested $100,000 in the business and holds 50% of its stock.  The company is currently valued at $700,000.  Owner A dies.  The company uses its death insurance proceeds to buy out A's shares.  A's shares become treasury stock.  B remains the sole owner of the corporation.  B's shares are now valued at $700,000 - the full value of the corporation.  B's basis in the stock is $50,000.  When he sells his shares, he realizes taxable gain of $650,000.  On the other hand, if A and B cross-insured each other, then upon A's death, B would pay $350,000 to A in insurance proceeds to purchase A's stock.  B's basis in the stock would then be $400,000.  So, his realized taxable gain on the sale of this stock would be much smaller, $250,000.  In this oversimplified scenario, using a cross-over arrangement results in significant tax savings for the surviving partner.

In conclusion, I recommend for all small and closely held businesses to consider entering into buy-sell agreements or including buy-sell provisions in their shareholder, partnership or operating agreements.  Drafting buy-sell agreements requires not just legal, but also financial and tax expertise.  It is worth the investment of time and money to ensure successful business continuation.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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