by Jennifer A. Grady, Esq.
Failing to create a formal transition plan in the event of the death, disability, retirement, or divorce of the business owner, or the transfer or sale of the business, is a drastic mistake that is frequently made by the owners of closely-held corporations. This lack of planning can be fatal to a business that does not have a formula for valuing tangible property, such as vehicles, real estate, and equipment; and intangible property, such as licenses, trade names, patents, trademarks, client lists, and goodwill.
A buy-out agreement, also known as a buy-sell agreement, is a legally binding contract between co-owners of a business that governs the situation if and when a co-owner dies or leaves the business. Every co-owned business needs this agreement the moment the business is formed, or as soon as possible after the formation. A buy-out agreement not only protects the remaining business owners when a co-owner intends to leave the company, but also provides protection for the owner who leaves the business. A buyout agreement acts as a sort of “premarital agreement” to protect each owner’s interests by setting the price and terms for a buyout. It is sometimes referred to as a “business will.”
In many cases, the spouse or children of a deceased business owner will demand payment for the deceased owner’s shares. Furthermore, lawsuits are common in community property states when the business does not have a plan in place to fund this potential obligation. By creating a buy-sell, or “buy-out” agreement, the owners can set a price or formula for calculating the price to be paid for the assets. Absent such an agreement, the valuation of business upon death, retirement, withdrawal, or expulsion of one of the principals is often expensive and controversial because it is likely that the remaining parties will have differing views that serve their own interests.
When creating a buy-out agreement, the parties must decide which events trigger a mandatory or optional buy-out of their shares. The most common triggering events are the death of a shareholder; a bona fide offer to buy the shares from one or more existing shareholders; voluntary or involuntary termination of a shareholder’s employment; shareholder retirement; shareholder disability due to injury or disability; and shareholder bankruptcy.
The Purpose of a Buy-Sell Agreement
A buy-out arrangement for a closely-held corporation can meet the following objectives.
- Prevents unwanted outsiders or inactive heirs from acquiring ownership interests and getting involved in the affairs of the business;
- Prevents insiders who retire, or are no longer active in the business, from continuing to hold shares;
- Provides continuing ownership and control in the remaining shareholders;
- Prevents shareholders from selling to other shareholders so as to disturb existing control/financial allocations;
- Provides an assured market for the shares (and thus, liquidity) upon a shareholder’s death, retirement, or withdrawal from the corporation; and
- Establishes the shares’ value for estate tax and gift tax purposes.
Funding a Buy-Sell Agreement
An important aspect of buy-sell planning is to ensure that sufficient funds will be available to make the purchase of stock called for under the agreement. The principal sources generally considered are:
- ACCUMULATED EARNINGS– where the agreement contemplates a stock redemption by the corporation, the corporation will need accumulated earnings available for this purchase. However, there are two potential difficulties that may occur when relying on accumulated earnings to fund a buy-out:
- The risk of penalty tax on accumulated earnings, and
- The corporation cannot lawfully perform the buy-sell agreement if there are not enough earnings to meet the statutory requirements for corporate distributions.
To avoid this problem, consider the possibility of an installment purchase, which spreads the payments over several years, during which additional future earnings could be accumulated.
2. INSURANCE– insurance is often used to fund a buy-out upon the death, disability, retirement, withdrawal, or incompetency of a shareholder. Any accrued cash surrender value can provide funds for the buy-out.
Who pays for/owns the policy?
- Under a corporate buy-out plan, the corporation will generally pay the premiums and own the life and/or disability policies on the life of each shareholder that provide the funds necessary for the redemption or repurchase.
- Under a cross-purchase buy-out plan, each shareholder owns a policy of insurance on the life of every other shareholder.
- Creation of a trust- as an alternative, the shareholders can create a trust to purchase and own an insurance policy on the life of each shareholder. The trustee would be instructed to collect the insurance proceeds upon the death of any shareholder, and would use them to purchase the decedent’s stock and distribute the stock pro rata to the surviving shareholders.
Note: Premiums paid on life or disability insurance to fund a buy-out are not deductible by either the corporation under a stock redemption plan, or by the shareholders or their trust in a cross-purchase plan.
The value of insurance policies can be determined by each business owner’s salary or proportional interest in the business. If the business closes or the partnership dissolves during the co-owners’ lifetime, the shareholders can continue to own their own policies and to use the policy’s potential cash value to supplement retirement income or to fund a buy-out of the business. When considering the various buy-sell agreement and funding options, it is recommended that shareholders consult with a qualified team of professionals, including attorneys, licensed insurance agents, and certified public accountants (who can also act as business valuators).
To determine whether to create a close corporation, and/or to learn how to create and fund a buy-out agreement, please contact The Grady Firm to schedule a complimentary 15-minute consultation. Call (323) 450-9010, or fill out a Contact Request Form.
Have you had a situation where a buy-out agreement prevented a difficult situation? Conversely, did you have a major problem with a shareholder or his/her family because you failed to have a buy-out agreement in place? Share your stories below.
Disclaimer: this material is provided for informational purposes only, and should not be construed as legal, financial, tax, or accounting advice. It should not, and cannot, be used for the purpose of avoiding U.S. federal, state, or local tax penalties. Please consult a licensed attorney to discuss buy-out options, and a licensed insurance representative before making any insurance purchases.