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How Shareholder Buy-Sell Agreements Can Protect
You and Your Family Against Catastrophic and
Unpredictable Loss
Small companies frequently have two or more
owners in partnership together. What happens
when one of those partners dies unexpectedly?
What if that partner is you? How would your
family survive financially if all your money is
tied up in the business? What happens if your
partner dies suddenly? Will you have enough
money to carry on—and to purchase your partner’s
interest in the company?
These often catastrophic situations are at best
difficult, but a shareholder buy-sell agreement
can go a long way to limit the financial impact
on business owners and their families by
providing a basic framework to support and
assist them in transitions which are often
unpredictable and uncontrollable. Surprisingly,
few businesses have up-to-date buy-sell
agreements in place to secure their financial
future when such events do occur. And these
events do happen frequently, creating confusion
and uncertainty at the worst possible time,
often throwing a healthy business into crisis.
A buy-sell agreement fixes the value of
interests in a company thus avoiding tax
problems as well as disputes between surviving
owners and the families of deceased owners. It
provides insurance funds to buy out a deceased
partner’s interest, prevents the company from
being depleted financially, and furnishes money
to the surviving family. And it allows for an
orderly transfer of ownership from the deceased
business partner to the surviving partner(s).
The buy-sell agreement also provides the
surviving owner(s) with the funds necessary to
overcome the loss of a key partner in the
business. It also provides financially for an
owners’ long-term or permanent disability. It
limits the ability of new owners to buy into the
business without the current owners’ consent.
And it even helps provide for a partner’s
retirement, withdrawal or expulsion from the
business.
Forward
Thinking
A shareholder buy-sell agreement is not a crisis
document. Rather, it is a well-planned agreement
which allows partners to deal with unpredictable
business situations in the best way possible.
What does a well-designed shareholder buy-sell
agreement look like?
First, the buy-sell agreement should reflect the
principal goals of the company’s owners with
respect to business operations and
succession. For example, the owners may be
primarily concerned with: (1) keeping the
business in the family by bringing in and
grooming a family member to succeed the owner,
(2) getting a former owner’s money out of the
business, (3) passing on the high-pressure parts
of the business to someone else, while remaining
less active in the business and gradually
working toward full retirement, or (4)
preventing the transfer of one partner’s
interest to a hostile third party which the
other partners do not want.
Second, the buy-sell agreement should provide
for three critical events triggering succession:
death, life-time transfers and disability.
Buy-outs resulting from either death or
disability can be funded with insurance which is
used to purchase the stock of the selling
shareholder (or his or her estate). Funding
difficulty can arise 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 is 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. The buy-out 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 agreement should fix a fair
value to the ownership interests involved.
Three commonly used ways to value a business
interest for buy-sell purposes include: (1) a
flat figure agreed upon yearly by the partners,
(2) a formula (e.g., a set multiple of
cash-flow, or “ebitda”), or (3) a procedure
(e.g., an independent valuation by a specified
expert or firm).
Fourth, a good buy-sell agreement should provide
for regular review and updating of the company’s
valuation and available insurance.
The buy-sell agreement should provide that the
ownership valuation is regularly updated and
adjusted for major changes impacting the
business such as: changes in profitability,
competition, insurance needs, business
ownership, the valuation of the business, or the
tax-law. If necessary, the agreement should
provide for a default procedure or formula that
automatically updates values where regular
updating is either ignored or the subject of
disagreement among the owners.
Corresponding updates and changes need to be
made to insurance carried on the lives of the
owners when the business valuation changes
substantially, when new shareholders come in or
old ones leave, or what is often called
“permitted transfers” are made within an owner’s
family.
Fifth, the buy-sell agreement should satisfy tax
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 an owner‘s
shares, (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 at arms
length and reasonably up to date. (In
family situations where the owners are related,
the tax requirements for valuation are much
stricter.)
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 dividend rates, satisfy what is
known as the attribution rules of IRC Section
302 which treat related persons or entities as
if each owned the other's shares. Special measures often need to be taken to
avoid intentional or inadvertent termination of
the S corporation election under IRC Sections
1361. Yet another issue which can have serious
effects is not violating the transfer-for-value
rule for life insurance, which can subject
normally tax-exempt life insurance proceeds to
ordinary income tax.
Sixth, a good buy-sell agreement should be
consistent with good governance and other
considerations.
For example, a buy-out of an owner may change
who has the majority vote in the business.
Non-competition and confidentiality provisions,
the business plan, the estate plans, retirement
plans and financial plans of the surviving
owners may also be involved. One of the
thorniest areas for planning is in the area of a
divorce. Short of an prenuptial agreement, a
buy-sell agreement will probably be vulnerable
to property and alimony claims of the divorced
spouse and the support claims of the minor and
pre-college age children.
While bad things happen in life, there is no
reason why the impact of unfortunate events
cannot be greatly lessened by having a good
buy-sell agreement in place.
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