The Importance of a Buy-Sell Agreement for Business Co-Owners
Posted by Benjamin Schuver on July 15, 2024
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Are you in the process of purchasing a business that will involve one or more co-owners? Or do you currently own such a business? If so, it is crucial to consider implementing a buy-sell agreement. A well-structured agreement offers several significant benefits, including:
- Increased Liquidity: It can transform your business ownership interest into a more liquid asset.
- Ownership Stability: It helps prevent unwanted changes in ownership.
- IRS Compliance: It can help avoid complications with the IRS.
Types of Buy-Sell Agreements
There are two primary types of buy-sell agreements: cross-purchase agreements and redemption agreements (also known as liquidation agreements).
1. Cross-Purchase Agreement: This is a contract between you and the other co-owners. Under this agreement, the remaining co-owners must purchase the withdrawing co-owner’s interest if a triggering event, such as death or disability, occurs.
2. Redemption Agreement: This is a contract between the business entity and its co-owners. In this arrangement, the business entity itself must purchase the withdrawing co-owner’s interest if a triggering event occurs.
Defining Triggering Events
You and your co-owners will need to define the triggering events to include in your agreement. Common events to consider are death, disability, and reaching a specified retirement age. You may also want to include other relevant events, such as divorce.
Valuation and Payment Terms
Ensure your buy-sell agreement clearly stipulates an acceptable method for valuing the business ownership interests. Common methods include:
- Fixed per-share price
- Appraised fair market value
- A formula based on a multiple of earnings or cash flow
Additionally, the agreement should specify how payments will be made to withdrawing co-owners or their heirs under various triggering events.
Funding the Agreement with Life Insurance
The death of a co-owner is often the most common and catastrophic triggering event. Life insurance policies can provide the financial backbone for your buy-sell agreement.
For a simple cross-purchase agreement between two co-owners, each co-owner purchases a life insurance policy on the other. If one co-owner dies, the surviving co-owner collects the insurance death benefit proceeds and uses them to buy out the deceased co-owner’s interest from the estate, surviving spouse, or other heir(s). These proceeds are typically free of federal income tax, provided the surviving co-owner originally purchased the policy.
However, cross-purchase arrangements with more than two co-owners can become complex, as each co-owner must buy policies on all the other co-owners. In this case, you might consider using a trust or partnership to purchase and maintain one policy on each co-owner. If a co-owner dies, the trust or partnership collects the death benefit proceeds tax-free and distributes the cash to the remaining co-owners, who then use the funds to fulfill their buyout obligations under the agreement.
For a redemption buy-sell agreement, the business entity itself purchases policies on the lives of all co-owners and uses the death benefit proceeds to buy out deceased co-owners.
Specify in your agreement that any buyout not funded by insurance death benefit proceeds will be paid out under a multi-year installment arrangement. This provides flexibility and time for the remaining co-owners to gather the necessary funds.
Securing Certainty for Heirs
For many business co-owners, the value of their business share comprises a significant portion of their estate. A buy-sell agreement ensures that your ownership interest can be sold by your heirs under terms you approve. Additionally, a properly drafted agreement sets the value of your ownership interest for federal estate tax purposes, thereby avoiding potential IRS complications.
Conclusion
As a business co-owner, having a well-drafted buy-sell agreement is essential. It provides financial protection for you, your heirs, and your co-owners, while also preventing IRS issues related to estate taxes. Contact us to help you set one up.
To learn more about transferring your business whether through a sale, generational transition, or change in leadership, join us in-person on October 1, 2024 at 8 AM at the Buffalo Club for a panel discussion on Minimizing Risks & Maximizing Value: Strategies for a Successful Ownership Transfer.
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As a manager, Ben’s responsibilities include the valuation of businesses, business interests, and intangible assets for purposes of financial reporting, transaction advisory, and tax planning and compliance. Additionally, Ben’s role includes performance of various forensic accounting procedures, as agreed upon with clients. Ben’s prior experience includes performing assurance services for publicly traded companies within the aerospace and manufacturing industries, as well as large private companies and the gaming industry. He also has experience in testing and evaluating internal controls over financial reporting.