Over the past 20 years or so, I’ve met with hundreds of business owners around the country, consulting them on a variety of topics including tax, business valuation, exit planning and risk management. Owners spend virtually their entire lives building their businesses with hope of creating a valuable asset that they can eventually sell or transfer in order to achieve a lifetime of financial independence.
Anyone who’s walked in those shoes can tell you that it’s harder than it sounds. The journey from starting a business to the eventual monetization of this illiquid asset is plagued with landmines along the way. One such landmine that we encounter on a regular basis is an improperly created buy/sell agreement.
A buy/sell agreement is a document drafted between two or more business owners that addresses how an owner’s interests are triggered and liquidated in the case of life events such as death, disability, divorce, departure (whether voluntary or involuntary) and dissolution. This document is meant to clarify and simplify the process during this difficult time in a business life cycle.
Unfortunately, in many cases, these documents are drafted in an uncoordinated manner that results in the exact opposite. The following are four key points that should always be considered when drafting your buy/sell agreement.
When drafting provisions for valuing the business upon a triggering event, careful consideration should be given to the method for valuing the business interest. Over the years, I’ve seen provisions utilizing methods such as flat amounts, book value, fair value and fair market value. While these are valiant attempts at addressing the issue, each of the aforementioned methods has a significant consequence for the parties involved.
A flat amount will not consider appreciating or depreciating the value of the business. We once reviewed an agreement that stated a flat $500,000 as the value of the business in the case of a triggering event. However, the owners hadn’t considered that the value of the business had grown to $4 million; clearly not a fair and equitable result to all parties.
Book value presents another dilemma. Because many businesses use different accounting methods for tax and financial reporting, consideration should be given to which “book” should be utilized. Furthermore, under this provision, the IRS can apply a significantly higher value to the business interest for tax purposes — accounting not only for the tangible business value, but also for the intangible value that is trapped in the business, such as goodwill.
The final two methods, fair value and fair market value, are often used interchangeably, and each method can result in significantly different values. The greatest cause for such differences is the implementation of discounts for lack of marketability and control — another consideration that should be addressed in the document.
Funding the Agreement
In the event of the death of a partner, the agreement should address how that interest will be redeemed. There are typically two methods that are adopted: the redemption and the cross purchase methods.
Under the redemption method, the corporation redeems the interest and brings it back into treasury.
Under the cross purchase method, each shareholder purchases the deceased shareholder’s interest. This method typically provides a greater tax advantage to the acquiring shareholder — in that it provides for an increased basis to that shareholder. Basis is considered the “cost” portion of the ownership interest that can be returned tax free. Any redemption value in excess of the basis will be subjected to taxes.
By not properly addressing this key provision, the remaining shareholders could be subjected to a substantial tax obligation when they liquidate their interest. But how does this redemption or purchase get funded? Funding is typically provided by the use of term insurance. Utilizing insurance provides the remaining owners with a tax-free benefit with which to acquire the departing shareholder’s interest.
One of the pitfalls in funding the buy/sell agreement revolves around the amount of insurance to acquire, who will own the insurance and how to fund other triggering events, such as disability. Insurance must be properly coordinated, which will become clear in a few paragraphs.
What about a triggering event such as disability or a non-insurable event? For disability provisions, the agreement can be funded with a disability buyout policy. This type of policy provides for a lump sum payout upon the disabled shareholder being defined as such by a physician.
In the case of a non-insurable event, the most common method for funding the departure is through the company’s cash flow. In this situation, careful provisions should be addressed in the agreement for terms such as payout timing and interest rates, if only so that the company will not be “strangled” by meeting the debt obligation.
Lack of coordination can also lead to unintended consequences. As described above, ownership and beneficiary of insurance policies can play a significant role in the tax consequences upon a triggering event.
This is particularly important if you’re operating a C corporation. Over the years, I’ve seen countless insurance policies designating a C corporation as the insurance beneficiary. The consequence of this structure is that the insurance proceeds, typically a tax-free benefit, have just been made taxable.
A buy/sell agreement should also be coordinated with other estate planning documents. In our travels, we’ve seen cases where business owners have established estate planning documents, drafted buy/sell agreements, and purchased life insurance to protect the company and the family. The problem with this scenario is that none of the advising professionals communicated with each other, causing the structure to be almost catastrophic, not only to the business, but to the family. Unfortunately, these circumstances are not known until the event occurs and the agreement is triggered.
The fundamental purpose of a buy/sell agreement is to memorialize the intentions of the business owner. The following are some additional points to consider when drafting a buy/sell agreement:
- Stay away from boilerplate agreements. Each situation is unique and each should be drafted as such.
- The buy/sell agreement is a living document. Over time, the owner’s intentions change and so too should the provisions of the agreement.
- Have a true understanding of how the provisions of the agreement will work. I recommend conducting a “fire drill.” Gather your advisors and rehearse the consequences of the triggering event to determine if any unintended consequences will arise.
- If you’re a single owner in the business, create a contingency plan that will consider many of the provisions stated in a buy/sell agreement.
Buy/sell agreements are intended to create clarity in times of turbulence. Having a properly drafted and updated agreement that creates little, if any, ambiguity will benefit all parties involved. Remember, many times when the agreement is triggered circumstances are not pleasant. In many cases, the remaining parties will be negotiating, not with their long-time partner, but with their spouses — and legal counsel. Yes, we’ve seen many of these situations tied up in years of litigation.