Why is a Buy-Sell Agreement a non-negotiable when starting a business?
When you start a business, there is a lot of planning that goes into it. But, something important that can go overlooked is establishing a plan for what happens when an owner can no longer participate in the company. It could be because of disability, death, retirement, etc., but at some point an owner will leave.
And the lack of a clear exit strategy can hurt everyone involved.
This is why buy-sell agreements are so important.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a contract between business co-owners that establishes the terms and conditions for transferring ownership interests if/when certain triggering events occur. You can think of it as a prenup between business partners.
It outlines who can buy, who must sell, and at what price when circumstances change.
They specify valuation methods, payment terms, funding mechanisms, etc. By establishing a buy-sell agreement, you can lessen uncertainty and avoid conflict during an already stressful situation.
What circumstances are a buy-sell agreement useful for?
Death of an owner
Permanent disability or incapacity
Retirement or voluntary withdrawal
Involuntary termination or breach of employment
Divorce or personal bankruptcy of an owner
Desire to sell to outside parties
Who Should Create a Buy-Sell Agreement?
Any business with multiple owners should implement a buy-sell agreement. This includes:
Partnerships and LLCs: Multi-member businesses where partners have invested capital or where one member leaving would impact operations.
Closely-Held Corporations: S-corps and C-corps with multiple shareholders, or family businesses where ownership may transfer across generations.
Professional Practices: Medical practices, law firms, accounting firms, etc. where personal relationships and professional licenses are necessary for operations.
Family Businesses: Companies where family members work together and ownership may transfer to the next generation.
Sole Proprietorships: Even sole proprietors should consider buy-sell provisions if they plan to bring in partners or if they want to ensure their business can be sold to key employees.
Buy-sell agreements can be as straightforward or as complex as you want, but their sophistication usually depends on the complexity and value of the business. For example, a two-partner firm might need more basic provisions whereas a multi-generational company with dozens of shareholders might need more comprehensive planning.
Why are buy-sell agreements better to establish when the business is new?
The best times to establish a buy-sell agreement are right when the business is made, or when new owners are brought in. Why?
Rational Decision Making: When a business is newer, owners should be able to make more objective decisions without personal conflicts getting in the way.
Equal Bargaining Power: Early in the business’s life owners usually have relatively equal bargaining positions, which leads to more balanced agreements.
Lower Valuations: Establishing valuation methods when the business is smaller can be advantageous for tax planning and transfer strategies.
Simpler Implementation: Incorporating buy-sell provisions into initial partnership agreements or corporate bylaws is easier than retroactively making changes.
Even if you already have a buy-sell agreement in place, you should review and update it as needed to reflect changing ownership structures and business circumstances.
Tax Implications of Buy-Sell Agreements
Buy-sell agreements have significant tax implications that impact the business and individual owners. How does a buy-sell agreement affect my tax situation?
Valuation for Tax Purposes: The IRS may accept the valuation method specified in a buy-sell agreement for estate and gift tax purposes, if the agreement meets requirements. The valuation must be determined through an arms-length process, restrict transfers during the owner's lifetime, and reflect fair market value.
Estate Tax Benefits: A buy-sell agreement can establish the value of a deceased owner's business interest, potentially reducing estate tax liability. This is helpful for high-net-worth families where business interests represent a significant portion of their estate.
Gift Tax Considerations: When business interests are transferred to family members through buy-sell agreements, the transaction can trigger gift tax consequences. However, valuation discounts and strategic timing can minimize these impacts.
Income Tax Treatment: The tax treatment of buy-sell transactions varies depending on the structure. Redemptions by the entity may be treated as dividend distributions or capital gains, while cross-purchase arrangements typically result in capital gains treatment for sellers and a stepped-up basis for buyers.
Installment Sale Benefits: Buy-sell agreements often provide for installment payments, which can spread the tax liability for sellers over multiple years, potentially reducing overall tax burden.
Impact on Your Business
Buy-sell agreements influence how your business operates and adapts to changing circumstances.
Business Continuity: Buy-sell agreements ensure your business can continue operating when ownership changes occur. Without clear succession planning, businesses can struggle or fail when owners depart unexpectedly.
Cash Flow: The agreement's funding mechanisms impact your business's financials. Entity-funded redemptions require the company to maintain liquidity or financing capability to purchase departing owners' interests.
Valuation Certainty: Regular valuation updates required by buy-sell agreements help owners understand their business's worth and make informed decisions about growth, acquisitions, or exit planning.
Relationships: By establishing clear rules upfront, buy-sell agreements can help preserve business and personal relationships when difficult situations arise.
Impact on Your Financial Picture
From a wealth management perspective, buy-sell agreements significantly influence financial planning for business owners.
Liquidity: Business interests are usually illiquid. Buy-sell agreements provide a way to convert business ownership into cash, which is important for retirement planning, estate liquidity, and diversification.
Estate Planning: These agreements must be coordinated with your overall estate plan. The timing and structure of ownership transfers can impact generation-skipping strategies, charitable giving plans, and overall wealth transfer efficiency.
Retirement Planning: For business owners whose wealth is concentrated in their company, buy-sell agreements provide clarity about how you can access that wealth for retirement funding.
Insurance and Funding Mechanisms
Most buy-sell agreements require significant funding to execute ownership transfers, meaning insurance is an important part of your planning.
Life Insurance: Life insurance is the most common funding mechanism for death-triggered buyouts. It provides immediate liquidity and can be structured through entity-owned policies or cross-purchase arrangements (where owners insure each other).
Disability Insurance: Disability buyouts require specialized disability buy-out insurance, which provides funds to purchase a disabled owner's interest after a specified waiting period.
Key Person Insurance: Businesses may maintain key person life insurance on crucial owners to help fund business continuation and transition costs beyond just purchasing the departing owner's interest.
Cross-Purchase Buy-Sell Agreements
In cross-purchase agreements, individual owners (rather than the business entity) have the right and obligation to purchase a departing owner's interest. They are one of the most common structures in buy-sell agreements. Why?
Tax Advantages: Cross-purchase structures usually have preferential tax treatment for buyers. That’s because they receive a stepped-up basis in the acquired interests equal to their purchase price, which can reduce future capital gains taxes when the business is eventually sold.
Insurance Efficiency: Each owner purchases life insurance on the other owners, with policy proceeds used to fund buyouts. This can be more tax-efficient than entity-owned insurance in certain circumstances.
Real Estate Considerations
When businesses own real estate, buy-sell agreements must address how property interests transfer and whether real estate valuations are included in the overall business valuation.
Separate Valuations: Some agreements separate real estate from operating business assets, allowing for different treatment of each component.
Lease Arrangements: If departing owners keep real estate while selling business interests, the buy-sell agreement should address ongoing lease terms and rent obligations.
Development Rights: For businesses with development potential in their real estate, buy-sell agreements must clarify how future development rights and associated values are handled.
Buy-sell agreements are one of the most important parts of business planning. They can provide certainty in otherwise uncertain times, protect family and business relationships, and impact tax liabilities and wealth transfer efficiency.
As with most contracts it’s best to establish a buy-sell agreement before you need it, so that decisions can be made rationally.
As always, we recommend working with a tax professional who understands both tax strategies and wealth management.
Author: Rob Cucchiaro, CFP, CRPC, AAMS
Questions answered in this blog:
What is a buy-sell agreement?
Why does a buy-sell agreement need to be made?
What situations are made easier when a buy-sell agreement is in place?
Who should create a buy-sell agreement?
Do I need a buy-sell agreement if I own a partnership?
Do I need a buy-sell agreement if I own an LLC?
Do I need a buy-sell agreement if I own an S-corp?
Do I need a buy-sell agreement if I own a C-corp?
Do I need a buy-sell agreement if I own a private practice?
Do I need a buy-sell agreement if I own a sole proprietorship?
Do I need a buy-sell agreement if I own a family business?
When is the best time to establish a buy-sell agreement?
How does a buy-sell agreement affect my tax situation?
How does a buy-sell agreement affect my business?
What impacts does a buy-sell agreement have on my overall financial planning?
What impacts does a buy-sell agreement have on my estate planning
What impacts does a buy-sell agreement have on my retirement planning?
How does life insurance come into play in buy-sell agreements?
How does disability insurance come into play in buy-sell agreements?
What is a cross-purchase buy-sell agreement?