A buy-sell agreement is essential in business succession planning, especially for small businesses with multiple family groups involved in ownership. These agreements are relevant for corporations and limited liability companies (LLCs). They outline the conditions under which an owner’s stake in the business may be bought out, such as in cases of death, disability, job termination, or divorce. To ensure financial security, these agreements often incorporate life or disability insurance.
Why Businesses Need Buy-Sell Agreements
Such agreements are crucial for addressing potential events that could jeopardize the business’s success. For instance, in a company with two owners, the remaining owner might not want to share ownership with the deceased owner’s family. Challenges that might arise include:
- Needing to employ additional staff to replace the deceased partner.
- Reluctance to share decision-making and profits with a non-active partner.
- The deceased partner’s family might not be involved in the business operations.
- The deceased partner’s family might require financial compensation for the lost income.
A well-structured buy-sell agreement, especially one backed by life insurance, can address these concerns. It can define the business’s valuation method, payment terms, and other essential details.
Types of Buy-Sell Agreements
Cross-Purchase:
In this format:
- The remaining owner buys the deceased owner’s stake directly from their heirs.
- The shares or business interest’s income basis increases by the amount paid.
- It bypasses any laws that limit direct distributions from the business.
- It avoids potential conflicts of interest and valuation discrepancies related to death benefits.
However, cross-purchases can be complex. For instance, in a two-owner setup, each owner would have a life insurance policy on the other. The number of policies increases with more owners, but this can be streamlined using an insurance partnership or LLC.
Redemption Format:
The business repurchases the stake upon an owner’s death or another triggering event. While seemingly straightforward, this method has its complications:
- It doesn’t offer an increase in basis upon purchase.
- Legal restrictions might affect the payment process.
- Valuation discrepancies can arise in the Thomas Connelly v. United States case, where the IRS argued for a higher company valuation than the stipulated buy-sell agreement.
Key Takeaways from the Connelly Case
The Connelly case revolved around two brothers, Michael and Thomas, who owned a family business. They had a buy-sell agreement, which required the company to repurchase shares from the first brother to pass away. When Michael died, the company bought his shares for $3 million. However, the IRS argued that the company’s value was $3.5 million more than the buy-sell agreement’s amount, leading to additional estate tax implications.
Lessons to Learn:
- Valuation Clarity: Ensure the business’s valuation is clear and aligns with the fair market value for tax purposes.
- Follow Procedures: If a valuation method is in the agreement, adhere to it.
- Clear Terms for Redemption Agreements: If life insurance is part of a redemption agreement, the terms should be explicit about how insurance death proceeds affect the business’s valuation.
The Bottom Line
For business owners, regularly reviewing and updating buy-sell agreements is crucial. These documents ensure smooth transitions during unforeseen events and protect the business and its stakeholders from potential legal and financial pitfalls.