Why Buy-Sell Planning Can’t Wait
Most business owners understand and appreciate the need for a properly drafted buy–sell agreement, but too many operate without one – the demands of day-to-day operations relegate such planning to the back burner. One thing I have heard too many times from business partners/co-owners is “when I die, my partner will do the right thing.” Maybe so, but death significantly changes the relationship balance and there is typically a lot of money at stake… a time when people get “funny.”
Consider the following scenario: Joe Client’s business partner died with a 1/3 ownership interest in a closely held business. The business was worth about $5,000,000. It was a good partnership and the three owners were friendly outside of work. They planned to implement a buy-sell agreement that would cover the death of a partner, but never completed the process. The business did, however, purchase life insurance for each partner in anticipation of the agreement. The end result was a long legal battle that worked out fine for the attorneys. The other parties to the process were less pleased.
The deceased partner’s spouse trusted the remaining owners but none of them had formally agreed what the ultimate value should be. It was only prudent for that spouse to consult advisors. The attorney advised that the value of the business needed to be determined and, in addition, the insurance was not structured in a way that left any indication it was intended to fund the buyout.
The remaining partners would not leave ownership with an unwanted party, so ultimately there was a settlement. In addition to the $1,500,000 of insurance proceeds the spouse already received, the business partners paid $1,000,000 in cash to buy back the interest of their deceased partner that they thought was pre-funded with insurance.
Buyout provisions are best worked out when everyone gets along. That’s the time when parties are in appropriate bargaining positions and a plan can be devised amicably. Often, a closely held business is an individual’s single largest asset and the uncertainty created without an agreement can only bring trouble.
After all, the key objective of a well-drafted buy-sell agreement is to create a definite and ready market for a closely held business interest that might otherwise be very difficult to sell. It limits the owners’ ability to transfer ownership to unwanted persons, usually by giving remaining owners or the business entity the “right of first refusal” at a predetermined price. Events such as death, disability, and retirement are typical triggers that would contractually obligate either the remaining owners or the business to make the purchase. This ensures that the parting owner will be able to liquidate interests.
Buy-sell agreements typically come in two flavors – entity purchase and cross purchase. An entity purchase agreement binds the business to purchase interests from a departing owner, while a cross purchase binds remaining owners individually. Each has its advantages and disadvantages. The type of business entity (S-Corp, C-Corp, Partnership, etc.) and the number of owners are key considerations to determining which is best.
If owners individually buy interests from the departing owner, their tax basis increases as it would with the purchase of other assets. Generally, when a business is the purchaser, the tax basis of the remaining owners doesn’t change.
This however can be overcome based on the type of entity and other considerations. There is no difference to the departing owner which type of agreement is in place, but the remaining owners could benefit greatly from an increase in tax basis if the business is later sold, reducing their taxable gain.
The more owners there are, the more cumbersome a cross purchase agreement becomes. Often, agreements are funded for triggering events such as death or disability by purchasing insurance. Once the options are considered, insurance is typically the most cost effective way to assure liquidity is available when needed. A cross purchase would require each owner to purchase insurance on all other owners. A business with six owners would require 30 policies.
A combination of a cross purchase and entity purchase agreement offers flexibility with respect to whether the individuals or the business will execute the buyout.
One party is ultimately bound by the agreement to make the purchase. These agreements need to be drafted carefully. If the language of the document binds the individuals, and the entity ultimately makes the purchase, the owners will likely be treated as being relieved of an obligation for tax purposes. This could result in dividend treatment to the owners equal to the amount of the buyout, and commensurate ordinary income tax liabilities that otherwise would have been avoided.
Business relationships are dynamic and sometimes sour unexpectedly. When one owner wants to leave or oust another owner, there is typically less agreement on what the terms and price should be. Buy-sell provisions often lack guidance for disharmony among owners.
An interesting provision often referred to as a push-pull or Russian roulette dictates that if an owner makes an offer to buy, the potential seller is left with the decision to accept or become the buyer at the same price and conditions in the original offer. This assures an offer will be well thought out and fair, because the instigator does not know if he/she will ultimately be the buyer or seller.
For many business owners, a relatively substantial business value creates or otherwise adds to a taxable estate at death. When an owner dies, the business must be valued for estate tax purposes. This value is often challenged by the IRS because of its subjectivity. The business is worth what a willing buyer will pay a willing seller, neither being under compulsion to buy or sell and both having knowledge of relevant facts. Although the rules are somewhat complex, a properly drafted buy-sell agreement can therefore fix the value of the business for estate tax purposes.
There are several tests to determine whether the agreement is “bona-fide.” These are more stringent when dealing with family members, but an agreement among non-related parties (or non-lineal descendants) typically is considered to be at arm’s length and would meet the tests. Many business owners have some flexibility in setting the value for the agreement because the value is subjective and they can agree at arm’s length so long as it is reasonable.
There is an important consideration here. Many negotiate for a higher value to provide greater benefit for their heirs and they then fund the obligations with insurance. A higher value could, however, increase the family’s estate tax burden in certain situations.
Perhaps the owners should not press for a higher than reasonable value simply to benefit their heirs since this could increase the tax burden. Alternatively, a lower, yet reasonable, value could be agreed upon and insured. The owners could then agree to buy additional insurance (perhaps with company funds) so that the family will realize the higher amount at death.
For example, assume two owners obtain independent appraisals valuing the business at $80,000,000 and $100,000,000. Rather than adopt the higher value in an attempt to maximize the amount their families receive at death, perhaps they should take the reasonable approach of averaging the two. There is no absolute value as evidenced by the range between the two appraisals. After consultation with advisers, they implement an agreement that fixes the value at $90,000,000 – clearly supported as reasonable.
They insure it with $45,000,000 of life insurance on each of their lives and each places an additional $5,000,000 of insurance in an irrevocable life insurance trust. The business also funds these premiums through bonuses or perhaps a more creative split-dollar arrangement.
If properly executed, the end result will be that each family will receive $50,000,000 as they would have if the agreement placed a $100,000,000 value on the business, but only $45,000,000 should be included in the taxable estate. This potentially saves the family tax on $5,000,000 – approximately $2,500,000 in tax savings considering both federal and state estate taxes.
A well-drafted buy-sell agreement is an absolute necessity for business owners, particularly when the intention is not to pass a business on to the next generation. It can help avoid potentially disastrous, litigious, and expensive disputes and also create dramatic tax savings. Your heirs will appreciate the time you took to decide and plan for the value of the business for both succession and tax purposes, rather than leaving it for the IRS to decide. And if you are on the surviving end of a transition, you may avoid some serious headaches yourself!
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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind.
The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.