When you own a company by yourself or with one or more partners, you pour your heart and soul into making it a success. Bringing a business into existence, nurturing it, and building upon it is so engrossing that it’s easy to lose sight of one sobering fact: You and each of your co-owners (partners or shareholders) will one day take leave of the company. It may be by retirement, disability, or death. Alternatively, someone may feel the need to move on, or a partner may be tempted by a third party’s offer for their share of the enterprise.
These situations could potentially throw a business and/or the deceased owner’s family into chaos. A family may be forced to sell its share to cover taxes on the estate if it can find a willing buyer. The remaining partners may be unable to get along with an interloper who comes into the business through purchase or inheritance. In an S corporation, the new shareholder may not be of a class eligible to hold such shares, thus forcing a reorganization.
A Versatile Tool
Buy-sell agreements provide a powerful business succession tool that owners of small-to-medium-sized companies can use to address any or all of these eventualities. A form of shareholder agreement, the buy-sell agreement, is a contract spelling out what will happen to the equity of a departing shareholder when a “triggering” event occurs.
Buy-sell agreements will generally fall into one of two categories:
- In a cross-purchase agreement, the shares or interests of the departing partner are to be bought by the surviving or remaining partners. In a sole proprietorship, the designated purchaser would be the owner’s chosen successor, whether a family member is involved in the business or a key employee vital to its continuation.
- In a stock redemption plan, the equity or shares are bought and retired by the corporation or partnership, thereby increasing the remaining shareholders’ share of the company’s equity.
The choice between these options will depend on the company’s structure and the resources available to fund the purchase. Agreements may set varying terms for different triggering events. For example, a lower price may be paid to a partner leaving to set up a competing business. Purchases might be mandatory upon the death or disability of a partner. In contrast, voluntary or forced withdrawals might give the business “the right of first refusal” to match a legitimate outside offer if it so chooses.
Often life insurance and, less frequently, disability insurance are used to fund buy-sell agreements. The contractual buyer purchases a policy on the prospective seller’s life. The proceeds are earmarked to purchase the business interest from the heirs of the deceased owner, and the cash value is available to fund purchases in other situations. In cross-purchase agreements, each owner needs to have a policy on the life of each of the other owners.
Because this process can be cumbersome with multiple owners, a stock redemption plan may be more workable. In that case, the business owns and funds a single policy on each owner’s life. Life insurance cash value is carried as an asset on the corporate balance sheet. It will not be considered an excess accumulation of earnings if it does not exceed the reasonable needs of the business.
The Hard Part
Placing a value on a closely held business can be a challenge, and placing a future value on one is next to impossible. For this reason, it may be best to specify a reasonable method that will be used to determine the price to be paid or to recalculate the price periodically.
Methods that may be appropriate, depending on the nature of the business, can be to:
- capitalize average earnings over a period of years,
- calculate the loan amount that the company’s cash flow will support,
- total the tangible assets on the balance sheet, place a value on the business’ intangible assets (often its customer base), or
- apply an industry rule of thumb.
Any method specified in a buy-sell arrangement representing an actual arm’s length valuation will be binding on the IRS for estate tax purposes.
A well-structured buy-sell agreement can provide a panoply of benefits:
- ensuring an orderly transfer of business interests,
- preventing forced liquidation,
- protecting the heirs of minority owners who otherwise might end up with a holding of restricted, non-dividend-paying stock,
- preventing a sale to outsiders or inheritance by someone not active in the business,
- persuading a pivotal employee to remain in the business, or
- establishing the value of a deceased owner’s shares for estate tax purposes.
If you own a business, we’re always ready to work with you and your advisory team to develop buy-sell agreements and can provide a wide array of other financial services to help your company thrive.
If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or email@example.com.
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Any developments occurring after July 1, 2022, are not reflected in this article.
This newsletter is provided for informational purposes only.
It is not intended as legal, accounting, or financial planning advice.