As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
What is a buy-sell agreement?
Buy-sell agreements are often used in business succession planning where the business is owned by a relatively small group of owners who would otherwise have a limited market in which to sell their business interests. A buy-sell agreement often provides the remaining shareholders or co-owners with the option of purchasing the business interests of a deceased or withdrawing co-owner before the business interest is sold to a third party. Business entities such as closely held corporations, LLCs, and partnerships frequently rely upon buy-sell agreements when creating future business succession plans. A buy-sell agreement is essentially a contract to buy and sell a departing business owner’s interests in a business at some point in the future, usually upon the occurrence of one or more specified events.
A buy-sell agreement is typically structured as either a cross-purchase agreement or a redemption agreement. A cross-purchase agreement is an agreement among co-owners to purchase each other’s business interests upon the death or other withdrawal of one or more owners from the business. These agreements typically specify a predetermined purchase price and, in some cases, are funded by life insurance purchased to insure the lives of the various business owners.
Why are buy-sell agreements often used in business succession planning?
Use of a buy-sell agreement in the business succession planning context can mean the difference between the orderly withdrawal of a partner, whether by death or otherwise, and possible loss of control over a business by the remaining co-owners. In general, business succession planning is intended to ensure that the following goals are met:
(1) Preserving a deceased co-owner’s wealth and providing liquidity for his or her estate;
(2) Providing the remaining owners with the security of knowing they will maintain control of the business without unwanted third-party intervention;
(3) Ensuring business continuity, if so desired by the remaining business owners;
(4) Fixing the value of the business interest for estate tax purposes to avoid potential IRS intervention.
Interests in closely held corporations, LLCs, partnerships and sole proprietorships can have very limited markets for sale. This is particularly problematic when a deceased co-owner either has no heirs to inherit the deceased owner’s interest or has heirs who are poorly equipped or unwilling to take over the business. If the deceased business owner passes the interests to children who are not interested in continuing the business, they may be forced to sell their inherited interests at a discounted price to a third party. Executing a buy-sell agreement ensures that the business owner controls the disposition of business interests by allowing that owner to choose the buyer in advance. This type of succession planning also protects the value of the business as a whole and ensures that this value will pass to the owner’s estate without the need for protracted post-death negotiation.
Use of a buy-sell agreement can also ensure that the remaining business owners can continue the business without interference from a deceased owner’s heirs or the need for a third party investor following that owner’s death or early withdrawal from the business. The existence of the agreement will prevent a small business owner from selling the owner’s interests to outside investors who may not share the business vision of the remaining co-owners.
How is a buy-sell agreement funded?
A buy-sell agreement can be funded by using the prospective buyer’s own funds, accumulated earnings, debt instruments or insurance (either life or disability).