The business continuity/planning tool known as the "buy-sell agreement" would not have been created if we all knew how long we were going to live or what the future of our businesses held. Unfortunately, the reality of life and death is that I could be struck by lightning before finishing this article…and though the odds of that happening are quite slim…there are a number of variables that could drastically change my future before the day's end. Many business owners choose to take the odds and play business continuity roulette. As long as all shareholders of the business stay healthy, happy and agreeable, everything goes according plan. But what happens when there is an unexpected death, disability or early retirement of one of the owners?

The "buy-sell agreement" is a binding agreement set in place today to protect against the unknown nature of the future. If a co-owner dies or is otherwise forced to leave the business, or chooses to leave the business, the agreement dictates what will happen in advance of the event. Think of it as a business "prenuptial agreement" or a "business will". The document typically outlines what triggers a buyout, who can/will buy the exiting owner's interest and how the interest will be valued.

When to draft the agreement

As the plan of any business is to start at zero and continually grow in to the future, the buy-sell agreement needs to be drafted on day one or as close to day one as possible. Every day the business operates, the value changes and so do relationships. The value on day ten might be easy to amicably agree to in the event of an early exit of one of the owners. However, the value or method of valuation, of the company at year ten after a shareholder dispute is significantly more complicated. If all parties agree on day one as to what an eventual transition looks like, less is left to chance or emotion.

Funding the agreement

A properly drafted buy-sell agreement should consider a buyout due to a number of events (death, disability, divorce, etc…). However, for simplicity's sake, let's look at funding the death of a co-owner. A common method used to fund these events is life insurance. Under an entity redemption arrangement, the business can purchase life insurance policies on each owner with the business itself as the beneficiary of the policy. The face amount of the policy should be sufficient to satisfy the value of the business as outlined in the buy-sell agreement. Pursuant to Internal Revenue Code Section 101, "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured". This allows for the business to receive the proceeds of the policy tax free and then subsequently redeem the ownership interest of the insured. Under a different arrangement referred to as a "cross purchase arrangement", each owner takes out a life insurance policy on the other at a level that satisfies the buy-sell value. Upon the death of one owner, the surviving owner receives the tax-free life insurance proceeds and then use the cash to buy out the interest of his/her former partner.

Value of ownership interest

When drafting the document on day one, it is impossible to know what the value will be a triggering occurs. In that regard, it is common for a valuation formula to be included in the agreement to mitigate the subjective nature of the "value of the business". One issue with the formula approach is that the business model can change from year to year and the formula in place may not be able to account for these changes. If a formula is used, it may be necessary to revisit the agreement annually to ensure that method of valuation is adequate. It is typical for an agreement to require a formal business valuation to be performed by an independent analyst in the event of a triggered buyout. This method protects against the possible inadequacies of a preset formula as the certified valuator is providing the value based on the business operations/assets at the time of the event. In these cases, some agreements explicitly indicate which Firm will perform the valuation when required to prevent disagreements in the future.

In Summary

The major issue surrounding the buy-sell agreement is whether or not the agreement accounts for all scenarios and is understandable at a later date. The more defined the agreement, the greater the chance that something could occur that is not covered by the document. Conversely, the more flexible the agreement, the greater the chance that future interpretations could be different. For help in finding that happy medium, please consult with your Dermody, Burke and Brown advisor.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.