If you own a business, you have hopefully established a buy-sell agreement in case you or a co-owner voluntarily or involuntarily leaves the company. The creation of the document is just one step in a larger process. You simply can’t draft the agreement and lock it away for safekeeping. The document should be a fluid one, you need to review and perhaps revise the document periodically.
The primary purpose of a buy-sell agreement is to legally confer on the owners of a business or the business itself the right or obligation to buy a departing owner’s interest. But a well-crafted agreement can also help ensure that control of your business is restricted to specified individuals, such as current owners, select family members or upper-level managers.
Another purpose of a buy-sell agreement is to establish a price for the ownership interests. You should engage a qualified appraiser to estimate the value of those interests when first making a buy-sell agreement, and periodically thereafter to ensure the price keeps up with the growing (or shrinking) value of your company.
Estate planning is also a priority for many buy-sell agreements. If your agreement was drafted more than a few years ago, you may need to update it based on recent gift and estate tax changes. For 2017, the top rate for the gift, estate and generation-skipping transfer (GST) taxes is 40% and the exemption limit is $5.49 million. However, also keep in mind that the President and Republicans in Congress have indicated a desire to repeal the estate tax.
As I alluded to at the start of this article, most buy-sell agreements lie dormant for years. What can quickly bring one to life is a “triggering event,” such as the injury or death of an owner, or, when one retires or voluntarily leaves the company. These are the major events that can bring a buy-sell agreement into play, but other occurrences such as changes to marital status can as well. Also, many agreements cover events such as conviction of a crime, losing a professional license or certification, or becoming involved in some other situation that is deemed inappropriate or illegal.
If you have not drafted a buy-sell agreement for your business, hopefully the wheels are now turning and you see the importance of having one. Let’s break down the different structures and options for agreements:
• Redemption, which permits or requires the business as a whole to repurchase an owner’s interest,
• Cross-purchase, which permits or requires the remaining owners of the company to buy the interest, typically on a pro rata basis,
• Hybrid, combines the two preceding structures. A hybrid agreement, for example, might require a departing owner to first make a sale offer to the company and, if it declines, sell to the remaining individual owners.
In choosing your buy-sell agreement’s initial structure, consider the tax implications. They will differ based on whether your company is a flow-through entity or a C corporation.
Buy-sell agreements require a funding source so that remaining owners can buy their former co-owner’s shares. Life insurance is probably the most common, but there are alternatives. If your company is cash-rich and confident in its ability to remain so, you could rely on your reserves. However, this could leave many businesses vulnerable to an unplanned cash shortfall. Another option is to create a “sinking fund” by setting aside money for paying out the agreement over time. Again, if your cash flow begins to suffer, you may not have enough funds when they become needed.
Keeping your buy-sell agreement updated requires some effort. That effort will pay off in saved time and prevented conflicts should a triggering event take place.
Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through www.HolbrookManter.com or at BRavencraft@HolbrookManter.com.