Editor’s Note: In-depth coverage of this issue can be found at Tax Facts Online, the premier reference on the taxation of insurance, employee benefits, investments, and small business.
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 (most commonly represented by their stock in the enterprise).
A buy-sell agreement can provide 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 and LLC’sfrequently 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 events: the stockholder’s death or, if also an employee, the stockholder’s retirement or the voluntary or involuntary termination of employment.
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.
The typical buy-sell agreement also specifies the method to be used to determine the repurchase price of the shares, selecting from such options as an agreed price with periodic revisions, a formula price based on book value or capitalization of earnings, or third party appraisal or arbitration.
A redemption agreement allows the business entity to purchase the interest of a deceased or withdrawing business owner upon the occurrence of previously agreed upon “triggering event.”
Typical triggering events include the death, loss of required professional license, retirement or disability of an owner or shareholder, or an involuntary transfer. (Photo: iStock)
When is a buy-sell agreement triggered? What are the differences between mandatory and optional buyout triggers?
A buy-sell agreement goes into effect upon the happening of specified “triggering events.” The parties to the agreement may build one or more triggering events into their particular buy-sell agreement, depending upon the anticipated succession issues. Typical triggering events include the death, loss of required professional license, retirement or disability of an owner or shareholder, or an involuntary transfer.
If the buy-sell agreement is triggered by an owner’s disability, the owners should include a definition of “disability” in the agreement to minimize disagreement between the buying and selling owners.Further, if using disability insurance to fund the agreement, the policy itself should contain a corresponding definition of disability that all parties understand.
This minimizes the risk that the buy-sell agreement will be triggered in the minds of the parties, but the insurance will not cover the disability that has actually occurred. Both the Uniform Probate Code and the Social Security Administration provide definitions of “disability” that may provide useful information to small business owners negotiating contract provisions.
Buy-sell agreements are perhaps most frequently triggered by the death or retirement of a business owner in the small business context.