Business owners should review buy-sell agreements.

Business owners should review buy-sell agreements.

The Importance of Buy-Sell Agreements in Business Succession Planning

A buy-sell agreement is a crucial component of business succession planning, particularly for small businesses with multiple family groups in the ownership structure. These agreements, applicable to corporations and limited liability companies (LLCs), provide for the possible or mandatory buyout of an owner’s interest in the business upon the occurrence of certain events such as death, disability, termination of employment, and divorce.

The Risks Without Buy-Sell Agreements

Without a buy-sell agreement, critical events like death or disability can place the business’s continued success and survival at risk. In a two-owner business, the surviving partner would rarely wish to be partners with the deceased partner’s spouse or children. This can lead to several issues:

1. The surviving partner may have to hire additional staff to cover the work done by the deceased partner.
2. The surviving partner may be less enthusiastic about sharing ownership, decisions, control, and profits with a passive, non-working partner.
3. The deceased partner’s spouse and children often do not work in the business.
4. The deceased partner’s family needs cash to replace the lost income.

The Solution: Buy-Sell Agreements

A properly drafted buy-sell agreement can solve all of these problems, particularly if funded with life insurance. These agreements establish the value or process to determine values, terms of payment, and other business terms for the surviving partner to acquire the business interest of the deceased partner.

Buy-sell agreements can be prepared in two formats: cross purchase and redemption.

Cross Purchase Agreements

A cross purchase agreement provides for the surviving partner to individually acquire the interest of the deceased owner from their family or other heirs. This format offers several advantages:

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• It provides a step-up in income basis in the shares or business interest for the amount paid.
• It avoids any corporate or state laws that may restrict distributions directly from the business.
• It helps avoid conflicts of interest in negotiations.
• It helps avoid valuing the business including the death benefit paid for tax and business purposes.

However, a cross purchase agreement can become more complex when multiple owners are involved. Each owner holds a life insurance policy on the other owner’s life. To simplify this, an insurance partnership or LLC can be formed, reducing the number of required insurance policies.

Redemption Agreements

A redemption agreement, on the other hand, provides for the business to reacquire the business interest upon the death of an owner or the occurrence of another event. While seemingly simple, redemption agreements raise additional issues for both income tax and business purposes. It doesn’t provide a step-up in basis at purchase, and corporate law distribution restrictions may interfere with the payment of the purchase price.

The Case of Connelly v. United States: Lessons to Learn

The case of Thomas Connelly v. United States highlights the importance of carefully reviewing buy-sell agreements. In this case, the IRS successfully argued that the value of the company for estate tax purposes was $3.5 million more than the agreed purchase price in the buy-sell agreement. This resulted in the seller being taxed for a higher value than what was received in the sale, leading to an additional $1 million in taxes.

The key lessons from this case are:

1. Value Determination: The fair market value of a business interest, as defined in the Internal Revenue Code, should be as finally determined for federal estate and gift tax purposes. This value should be based on the price at which the property would change hands between a willing buyer and a willing seller, with reasonable knowledge of relevant facts.

2. Follow Valuation Procedures: If a buy-sell agreement establishes a valuation procedure, it should be strictly followed. In the case of Connelly, the valuation procedure outlined in the agreement was disregarded during the sales transaction, leading to complications in the subsequent litigation.

3. Beware of Schedule A Valuation Method: Relying solely on the Schedule A valuation method is not advisable. If this method is used, it should have a short shelf life and a backup appraisal method should be incorporated.

4. Clear Definitions for Redemption Agreements: If a buy-sell agreement is a redemption agreement and life insurance is intended to be held by the entity, the agreement must clearly define the rules. It should specify whether the insurance death proceeds are to be counted in the determination of the enterprise value and whether all life insurance proceeds must be paid as part of the redemption price.

Taking these lessons into account and ensuring thorough review and adherence to buy-sell agreements can help business owners avoid costly tax consequences and ensure a smoother transition in the event of critical events. With the proper implementation of buy-sell agreements, business succession planning becomes a proactive and effective strategy for safeguarding the long-term success of any business.

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