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Succession Planning
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Shareholder
Buy
Sell Agreements and Succession Planning Protect Your Families Future
What happens if you, a business owner, are hit by a car?
How do you get the value out of your company for your family? What
happens if your partner is hit by a car? How do you carry on the
business without him, or take over his ownership interest? Very few
businesses have up-to-date plans in place which allow you to guarantee
your family's or your business' future.
FEATURES
OF A GOOD SHAREHOLDER BUY-SELL AGREEMENT
The shareholder buy-sell
agreement is probably the core legal document in succession planning.
It should be used by virtually all small businesses (and many larger
businesses as well). By buy-sell
agreements, I mean agreements solely between existing shareholders and business
partners to sell or buy their stock interest to each other or to the corporation
in the event of an owner’s or a partner’s death, disability, retirement,
expulsion, or outside purchase offer.
The buy-sell agreement between two or
more shareholders differs from the outright sale of merger in several ways: (1) the buy-sell transaction is deferred usually well into
the future with no fixed closing date; (2) it only takes place only if triggered
by certain events, which may never happen; and (3) it is reciprocal, in that
either or any partner may turn out to be the buyer or the seller, depending upon
what actually happens down the road.
A buy-sell agreement in not purely a
legal business document: it brings
in estate planning, financial planning, insurance, tax and business
considerations, as well. One of the
unique aspects of this type of agreement, is that the business owner must plan
for himself or herself, both as a potential buyer as well as a potential
seller, since no one knows which of the business partners will die first, become
disabled first, retire first or sell out first.
Another unusual feature of a buy-sell is that these agreements require
planning on two different and often competing levels:
the business level and the personal or family level.
The principal purposes of a shareholder
buy-sell are: (1) to assure the
orderly and agreed-on continuity and transfer of management of the business in
the hands of an existing partner, a chosen successor or a chosen outside
business owner; (2) to provide a means of withdrawing an owner’s money out of
the business, and (3) to fix stock values for estate tax and for other purposes.
There are two types of buy-sell
agreement: a redemption agreement,
where the corporation buys the stock of the selling stockholder, and a
cross-purchase agreement where the other shareholders buy the selling
shareholder’s stock.
While a buy-sell is essential to
business succession, the fact is that a great number of small businesses do not
have a shareholder buy-sell agreement, and many of those that do, have
agreements which are out-of-date and have not been adjusted for for major
changes impacting the business such as: changes
in profitability, changes in competition, changes in insurance needs, changes in
business ownership, changes in the valuation of the business, or changes in the
tax-law. (Such stale agreements have been very aptly named “time-bombs”.)
For succession plans to work best, you
and your partners should put
things in place in advance of any major event raising
issues of succession. A shareholder buy-sell agreement is not a crisis document.
It is a planned document which is part of a planned, thought-out
arrangement to attempt to deal with crises and to effect a transfer of a
business ownership interest and pay-out of a partner’s interest to the partner
or his family in as orderly manner as possible.
Here are some of the real-life crises
which confront business owners during the life of a business.
Your business partner suddenly dies, leaving you to run the business
alone - what do you do? Your
business partner just had a serious heart attack or a bad car accident and
can’t work in the business any more - what do you do?
Your partner is much older than you and now wants to retire and get his
money out of the business - what do you do?
Your business partner doesn’t want to be your partner any more, wants
out and wants his money back - what do you do?
Your business partner wants to sell his stock to your worst enemy and
start up a competing business - what do you do? You get a fatal heart attack, what does your surviving spouse
or your estate do? You survive the
heart attack but cannot work at the business any more, what do you do?
Your son (or daughter) wants to take over the business from you, sooner
rather than later, before you are ready to retire, perhaps he doesn’t want you
around much - what do you do? You
want someone to take over your business, escape the pressures of your business,
get your money out, but want to keep semi-active in the business and have a
place to go on weekdays after breakfast (rather than watch tv for the next 8
hours) - what do you do? These are
very common situations which recur again and again with business after business.
The shareholder buy-sell agreement attempts to deal with these situations.
What does a well-designed, well-drafted
shareholder buy-sell agreement look like?
First,
the buy-sell should reflect the basic goals of the business owners with respect
to perpetuation and succession, for example:
(1) keeping the business in the family by bringing in and grooming a
family member to succeed the owner, (2) getting an owner’s money out of the
business, (3) passing on the high-pressure parts of the business to someone
else, while staying active in the business but taking more time off and
gradually working toward full retirement.
Second,
the buy-sell should provide for the two or three critical events triggering
succession: death, life-time
transfers and disability. Buy-outs resulting from either death and disability can be
funded with insurance which can be used to purchase the stock of the selling
shareholder. Some difficulty arises
with a life-time transfer where either the corporation or the other shareholders
have exercised their right of first refusal to buy the selling shareholder’s
stock. Getting the funds to
purchase a shareholder’s stock during his or her lifetime can be more
difficult, because there are no insurance proceeds to fund the purchase and the
resulting drain of the Pay-out on corporate funds can be a real concern.
It is usually accomplished over time through a promissory note providing
for a stream of payments (with interest) over a five to ten year period.
Third,
the buy-sell should fix a value to the ownership interests involved and provide
for regular updating of that valuation, and finally, should provide for a
default procedure or formula in case the need for current valuation is ignored
or is the subject of disagreement. Like
any business, there are three principal ways to value an business:
(1) a flat figure agreed upon yearly by the parties, (2) a formula (for
example, a multiple of “ebitda”), or (3) a procedure (for example, an
independent valuation).
Fourth,
the buy-sell should satisfy various tax rules and requirements:
for example, in order to have the business valuation be acceptable to the
IRS, the agreement must provide for: (1) a life-time restriction on the transfer
of a party‘s shares and (2) a mandatory obligation to offer upon death the
deceased owner’s shares to the corporation or the other shareholders (who do
not have to be obligated to buy them), and (3) the valuation has to be
arms-length and defensible. (In
family situations where the owners are related, the tax requirements for
valuation are much stricter than otherwise.)
another tax requirement, also in family situations, is that the sale of
stock to the corporation must, in order to avoid being taxed at the higher rate
of ordinary income, satisfy what is known as the attribution rules of IRC
Section 302. Another example, is
that special measures need to be taken to avoid intentional or inadvertent
termination of the S corporation election under IRC Sections 1361 and following.
Yet another trap which is relatively rare but is catastrophic when it
happens, is the violation of the transfer for value rule for life insurance,
which can subject life insurance proceeds - normally tax exempt - to ordinary
income taxation.
Fifth, a
good buy-sell agreement should provide for periodic review and updating of the
company’s valuation. I mentioned the default formula for updating stock values
where the owners fail to update the values on their own.
But also, changes need to be made in
the amount of insurance carried on the lives of the various shareholders where
the business changes substantially in value, also or when new shareholders come
in or old ones leave, or what is often called “permitted transfers” are made
within an owner’s family.
Sixth,
a good buy-sell agreement should be keyed into and consistent with governance
considerations, possibly have a non-competition and confidentiality provision,
the business plan of the business, the estate plans, the retirement plans and
financial plans of the various owners. One
of the thorniest areas for planning (assuming you can plan for it) is in the
area of a marital divorce. Short of
an ante-nuptial agreement, a buy-sell will probably always be vulnerable to
property and alimony claims of the divorced spouse and the support claims of the
minor and pre-college age children.
A shareholder buy-sell agreement is
essential for serious planning for the future of the business owners, their
families and the business itself.
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