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 (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.”

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.

A triggering event can be either mandatory or optional.After the triggering events have been determined, the parties must determine whether they wish to provide that occurrence of the event makes purchase mandatory, or merely creates a right or an option to purchase under the buy-sell agreement. Like any other contract, the parties have freedom to negotiate the contract terms in a buy-sell agreement in order to reflect the specific needs of the business. There are three common rights that are negotiated in the context of buy-sell agreements, including (1) mandatory purchase requirements, (2) “call”-type options and (3) “put”-type options.

As the name suggests, if the parties provide for a mandatory purchase, all parties to the agreement will be obligated to complete the sale once the triggering event has occurred.

The agreement can also provide for a call-type option, under which the buyer is given the option to purchase upon the occurrence of the triggering event.In this case, if the buyer exercises the option, the selling owner is required to sell the interests.

Conversely, the agreement can provide for a “put” type option, under which the seller is given the option to sell upon the occurrence of a triggering event, and the buyer will then be required to purchase the interests.

In any of these three situations, the triggering event will be crucial to determining whether the provisions of the buy-sell agreement are activated. The parties must consider the fact that, as in any other option contract, if the rights are structured similarly to put or call options, the party giving the option will be free to exercise the option or not to exercise the option upon occurrence of the triggering event. On the other hand, the party who gave the option is bound to perform once the option is exercised within the terms of the agreement.[7]

How is a buy-sell agreement funded?

A buy-sell agreement can be funded through the use of the prospective buyer’s own funds, accumulated earnings, debt instruments or insurance (either life or disability).  While self-funding is possible, many selling business owners prefer the certainty that is provided through other funding methods. Self-funding presents the possibility that the buyer may be unable to obtain the funds upon the selling owner’s death or withdrawal.

As a result, many buy-sell agreements are funded with insurance. The type of insurance that is required will depend upon the triggering events specified in the buy-sell agreement itself. If a right to purchase under the agreement is triggered by the seller’s death, the buyer or business may fund the agreement by purchasing life insurance that insures the life of the selling business owner.

Death, however, is not the only type of event that may trigger a buy-sell agreement. If the triggering event is the selling owner’s disability or retirement from the business, funding may be provided more effectively through a disability insurance policy or a permanent life insurance policy that provides the potential for tax-free loans during the life of the insured. It is also common to treat an “involuntary transfer” as a triggering event. Essentially, this will become applicable if a creditor of an owner attempts to seize an interest in the business in pursuit of the collection of a debt. This can occur if an actual debt is owed to a third party or if one of the owners is party to a divorce proceeding and the interest in the business is being transferred to a spouse who is not an owner. In the event that an involuntary transfer is a triggering event, insurance will not likely be available to fund the purchase.

If the parties have entered into a cross-purchase agreement, insurance funding is accomplished by the business owners purchasing insurance on the lives of each participating co-owner. The entity itself may also set aside accumulated earnings to fund a buy-sell agreement. In a closely held corporation, however, it might be difficult to set aside adequate funds when the operation of the business could benefit from the use of these funds. Further, in case of a C corporation, accumulated earnings above $250,000 can be subject to the accumulated earnings 15 percent penalty tax.

(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.)