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Buy-sell agreements: multipurpose tools for business owners

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One of the most difficult types of assets to deal with in an estate plan is co-owned property, whether that’s real estate or a closely held business such as a law firm, a medical practice, or other entity.

It can be difficult to dispose of half that property after the client’s death in a manner that satisfies the co-owner. And the heirs will certainly want an ownership share if they plan to be involved in the business after the client’s death. But if the client still wants to be engaged in the business for as long as possible, it’s often not feasible to sell the property till after death.

One useful solution is a buy-sell agreement. A buy-sell agreement provides for the orderly buy-out of equity interests upon the occurrence of triggering events, most commonly death but for other purposes as well. The agreement can stipulate not just who the ownership will pass to but also how to determine the purchase price, the process and timing for the eventual buy-out. It’s also a valuable tool to be used if the client’s equity in the business might trigger the estate tax.

Let’s say the client wants to leave his share of a co-owned business to his two children. Upon the client’s death, the heirs are assured of having the right to purchase their share of the property.

The children would sign a buy-sell agreement, which could provide that the children are allowed to sell or transfer their interest during the client’s lifetime — but only to each other. If there were more people named in the agreement, they could sell their interest to any of them as well.

Without that buy-sell agreement, the client’s interest in the business will likely pass to his or her estate and be distributed in accordance with the estate plan. That could take a while to pass through all the proper channels; and the full value would be included in the client’s estate for tax purposes.

A buy-sell agreement not only ensures the heir’s ability to purchase the interest upon the client’s death; it also establishes an agreed formula for determining the purchase price. The agreement can also be used to purchase insurance to fund the buyout.

The agreement generally provides a formula for determining the sales price, which has to be fair market value. If the buy-sell agreement is undertaken as simply a way to evade the estate tax, the sale needs to be considered an “arm’s length transaction” to satisfy the IRS. If the designated buyer is not a family member, the stated purchase price generally pegs the value of the client’s interest for federal estate tax purposes.

Even with that arm’s-length value, the sales figure in a buy-sell agreement is generally fairly low. The fair market value will usually be less than half the value of the property because a buyer from outside the family would not likely pay full freight to be a lesser partner. 

These “valuation discounts” can help to minimize the client’s eventual estate taxes. If the purchase is funded through a life insurance policy, the heirs don’t have to put up any capital of their own.

One critical aspect is that, if the client so chooses, the share of the property can’t leave the family. The agreement can even insist that each family member’s will and living trust leave the property to family members of the client’s choosing, so it stays in the family in perpetuity.

A buy-sell agreement can also protect the property in the event of a divorce. Divorcing spouses generally have a claim on their ex-spouse’s property, and even in states where that’s not the case, they may have a right to be compensated for appreciated value of the business. A buy-sell agreement, by limiting the number of people with the right to buy into the property, can head off these issues by requiring the divorcing owner to sell his or her share back to the other owners.

Buy-sell agreements can be tricky, and they’re not for every business. But clients who do share in a business or other type of property will appreciate having this option at their disposal. 

See also these articles by Tom Nawrocki: