A business continuation (buy-sell) agreement is a legal contract providing terms for the disposition of a business interest in the event of the owner’s death, disability, retirement, or upon withdrawal from the business at some earlier time.
Business continuation agreements can take a number of forms:
- an agreement between the business itself and the individual owners (either a corporate stock redemption agreement or partnership liquidation agreement), frequently called an “entity” plan;
- an agreement between the individual owners (a cross-purchase or “crisscross” agreement);
- an agreement between the individual owners and key person, family member, or outside individual (a “third-party” business buy-out agreement); or
- a hybrid combination of the foregoing.
In the case of corporations, the most common types of business continuation agreements are stock redemption plans (often called stock retirement plans), or shareholder cross-purchase plans.
The distinguishing feature of the redemption agreement is that the corporation itself agrees to purchase (redeem) the stock of the withdrawing or deceased shareholder.
In a cross-purchase plan the individuals agree between or among themselves to purchase the interest of a withdrawing or deceased shareholder.
In the case of a partnership, an agreement similar to the corporate stock redemption plan is the partnership liquidation agreement, where the partnership in effect purchases the interest of the deceased or withdrawing partner by distributing assets in liquidation of the partner’s interest, or the partners agree to a cross-purchase similar to the corporate cross-purchase plan.
1. When should buy-sell agreements be considered?
There are a variety of circumstances under which the use of a buy-sell agreement may be advantageous:
- When a guaranteed market must be created for the sale of a business interest in the event of death, disability, or retirement.
- When it is necessary or desirable to help establish the value of the business for federal and state death tax purposes.
- When a shareholder or partner would be unable or unwilling to continue running the business with the family of a deceased co-owner.
- When the business involves a high amount of financial risk for the family of a deceased owner and it is desirable to convert the business interest into cash at the owner’s death.
- When it is necessary or desirable to prevent all or part of the business from falling into the hands of “outsiders.” This could include a buyout of an owner’s interest in the event of a divorce, disability, or insolvency, if there is a danger a business interest would be transferred to a former spouse or creditors.
- Where it is desirable to lend certainty to the disposition of a family closely-held business. Rather than relying on will provisions of a parent to transfer the business interest, a binding buy-sell agreement between parent and child or other relative could be used. However, under Code section 2703, this has become exceedingly difficult.
- When state law restricts the parties who can own an interest in the entity. An example is a professional corporation or association. State law might allow only licensed practitioners in that field, doctors for instance, to own the stock. In such a case, an heir or beneficiary of one of the doctors who is not a duly licensed professional in that field could not be an owner of an interest in the firm. A buy-sell agreement between the practitioners already in the firm or with a practitioner outside the firm (perhaps a friendly competitor) would be a legal and practical necessity.
2. What are the requirements?
A written agreement is drawn stating the parties to the agreement, purchase price (or a formula for determining that price), terms, and funding arrangements. The agreement typically obligates the retiring (or disabled) owner (or owner’s estate) to sell the business to:
- the business itself;
- the surviving owner(s);
- a third-party non-owner; or
- a combination of parties.
Occasionally the agreement combines the types of obligations.
For example, the agreement may give the remaining owners the option to purchase the stock or partnership interest, but provide that if they fail to exercise that option, the interest must be redeemed or liquidated by the corporation (or partnership).
Conversely, the agreement may provide that, if the entity cannot purchase the interest, the remaining owners have either an obligation or option to do so.
Such agreements must be carefully drafted to avoid a situation in which the entity discharges an obligation of the other individual owners to purchase the interest, which could have adverse tax consequences to the other owners.
For example, if the shareholders under the agreement are personally legally obligated to buy the stock of a deceased shareholder, and the corporation redeems (buys back) the stock, the entire amount of the obligation of which the remaining shareholders are relieved could be considered a taxable dividend to them. They would pay tax at ordinary income rather than capital gains rates.
3. What can trigger the obligations?
The buy-sell agreement specifies the event triggering the respective obligations.
Generally that event is death, disability, or retirement of the owner. However, as already indicated, it could (and usually should) include other potential events such as divorce, insolvency, or bankruptcy, and should also include such possible events as long term disability, loss of a professional license by an owner, or conviction of an owner of a state or federal crime.
Valuation may be based on several factors, including book value, asset value, formula value, or some agreed amount.
4. In this context, what does “funding” mean?
“Funding” pertains to how the promises under the agreement will be financed.
Generally – and preferably – in a redemption or liquidation agreement, the business will purchase, own, pay premiums, and be the beneficiary of adequate and continually reviewed amounts of life (and often disability income) insurance on each person who owns an interest in the business. In the case of a cross-purchase agreement, the prospective buyer (each business associate) purchases, owns, pays for, and is a beneficiary of a life and disability income insurance policy on the other owners.
—Read Cross Selling Life Insurance to Business Owners on ThinkAdvisor.