Crafting a Buy-Sell Agreement

June 1, 2021

Most companies with more than one owner should have a buy-sell agreement in place. Here are some of the key considerations involved in developing this legal document.

Buy-sell agreement benefits

A well-designed buy-sell agreement provides many benefits, including:

Keeping ownership of the business within the family or another select group, for example, people actively involved in the enterprise,
Preventing an owner’s former spouse from acquiring a business interest in the event of a divorce,
Providing owners and their heirs with liquidity to pay estate taxes and other expenses in the event of death or disability,
Establishing the value of the business for gift and estate tax purposes (if certain requirements are met), and
Minimizing disputes over ownership succession issues.

Typically, buy-sell agreements achieve these objectives by requiring or permitting the company or the remaining owners to purchase the interest of an owner who dies, becomes disabled or leaves the business. They also may provide the company or the remaining owners with a right of first refusal in the event an owner wishes to sell his or her interest.

The tax outcome

Generally, buy-sell agreements are structured in one of two ways: “redemption” or “cross-purchase.” Either of these will permit or require the company to purchase a departing owner’s shares. The latter confers that right or obligation on the remaining owners.

From a tax perspective, cross-purchase agreements are generally preferable. The remaining owners receive the equivalent of a “stepped-up basis” in the purchased shares. That is, their basis for those shares will be determined by the price paid, which is the current fair market value. Having the higher basis will reduce their capital gains if they sell their interests down the road. Also, if the remaining owners fund the purchase with life insurance, the insurance proceeds are generally tax-free.

Redemption agreements, on the other hand, may trigger a variety of unwanted tax consequences, including corporate alternative minimum tax, accumulated earnings tax or treatment of the purchase price as a taxable dividend.

The disadvantage of a cross-purchase agreement is that the owners, rather than the company, are responsible for funding the purchase of a departing owner’s interest. And if they use life insurance as a funding source, each owner will need to maintain insurance policies on the life of each of the other shareholders, a potentially cumbersome and expensive arrangement.

Estate planning goals

A buy-sell agreement can fit into the owners’ estate planning objectives. If your estate plan was drafted years ago, you may need to update it based on more recent gift and estate tax changes.

Specifically, the gift and estate tax exemption and the generation-skipping transfer tax exemption amounts have increased to $11.7 million, or $23.4 million for married couples, for 2021.

The selling price

The valuation provision of a buy-sell agreement is critical to avoiding unpleasant surprises or conflicts. Generally, the fairest and most effective method of setting the purchase price is to conduct periodic independent business valuations and to base the price on fair market value.

Many agreements set the price using a formula tied to earnings, cash flow, book value or some other objective measure. Although formulas offer simplicity and lower costs, they can’t account for subjective characteristics or other factors that drive business value. As a result, they often underestimate or overestimate business value, which can lead to disputes when the buy-sell agreement is invoked.

Keep it on your radar

Once your buy-sell agreement is finalized, don’t put it on a mental “shelf” for reference in the future. Stay alert for an event that could trigger the agreement such as grave illness, disablement or an owner voluntarily leaving the business.

You also may want to make sure your agreement covers events such as changes in an owner’s marital status. And to help prevent fraud or inappropriate behavior, many agreements include “conviction for committing a crime or becoming involved in a scandal” as a triggering event.