8993 / 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.¹ 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 the 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 value² of the business interest for estate tax purposes to avoid potential IRS intervention.

The courts have consistently considered the foregoing goals bona fide business reasons for entering into buy-sell agreements, as have the goals of maintaining exclusive family control over a business, assuring continuity of company management policies, and retaining key employees. However, the courts have also noted that “legitimate business purposes” are often ‘inextricably mixed’ with testamentary objectives where the parties to a restrictive stock agreement are all members of the same immediate families, and, as a result, have required taxpayers to satisfy both business purpose and non-testamentary disposition tests for purposes of valuing closely held stock for estate tax purposes.³

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.

Another individual may hold an option or contract to buy securities owned by a decedent at the time of death. The effect, if any, that is given to the option or contract price in determining the value of the securities for estate tax purposes depends upon the circumstances of the particular case, with little weight being accorded to a price contained in an option or contract under which the decedent is free to dispose of the underlying securities at any price during the decedent’s lifetime. For example, this is the effect of a shareholder’s agreement to buy whatever shares of stock the decedent may own at the time of death.⁴