Buy-Sell Agreements and the Closely Held Business
Volume 2 • Issue 9 • September 2012
The Counselor is a monthly newsletter of Hallock & Hallock dedicated to providing useful information on estate planning and business planning issues. This month's issue will discuss the importance of the buy-sell agreement in a closely held business. If you are interested in learning more about the ideas and processes discussed in this newsletter, please contact us for an initial consultation.
For owners of a closely held business there is perhaps nothing more important than the buy-sell agreement among the owners. A properly structured buy-sell agreement will protect the value of both the existing and remaining business owner’s interest in the business and prevent protracted disputes when an owner desires to exit the business. The buy-sell agreement is designed to establish a predetermined and agreed-upon business value (or method of arriving at the value) at the occurrence of certain trigger events such as the death, disability, divorce, deadlock, voluntary or involuntary termination of an owner, retirement of an owner or the attempted sale to a third-party. In addition to the preceding list, other “triggering events” could include anything that would jeopardize the business, such as the loss of a professional license.
Types of Buy-Sell Agreements
There are various types of buy-sell agreements, including stock redemption (equity purchase), cross purchase (surviving owners purchase), use of a partnership to hold insurance on the lives of multiple shareholders, and a hybrid or wait-and-see combination to give shareholders the right of first refusal. Each type has differing tax consequences, so it is important to thoughtfully consider the choice you are making to determine which will be right for you.
One of the most important features of the buy-sell agreement, of course, is its ability to set a value. A fixed price method is useful, but must be updated annually and should be supported by an appraisal to avoid disputes. A formula method can include book value, modified book value, capitalization of earnings and discounted future cash flows. Under the appraisal method, a single appraiser can be used, or the buyer and seller can each have an appraiser with any disputes resolved by a third appraiser. A recommended hybrid would be to use a fixed price that defaults to an appraisal if it is not updated.
The 2011 case of Estate of Cohen v. Booth Computers provides an excellent example of the problems that can arise if the valuation question is not properly considered. In Estate of Cohen, the partnership agreement provided for the mandatory buy-out upon the death of a partner. One of the partners, Claudia Cohen, died in 2007. The company was valued at approximately $45,000,000.00 at the time of Claudia’s death. If the value of her interest had been defined by fair market value, her interest in the company would have been equal to $11,526,162.00. However, because of the way the valuation clause was written, Claudia’s heirs received only $178,000.00 – a loss of more than $11,000,000.00!
Under the Internal Revenue Code, the transfer tax value is determined without regard to any buy-sell agreements among family members unless: a) the buy-sell agreement is a bona fide business arrangement; b) it is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and c) its terms are comparable to similar arrangements entered into by persons in arm’s length transactions. This is a very difficult burden to overcome. As a practical matter, what is paid under almost all buy-sell agreements has no relationship to what the IRS determines to be the value transferred.
Second only to establishing a value is establishing how the purchase price will be paid – this is known as “funding.” Funding methods can include retained earnings, sinking fund, installment purchase, third-party borrowing and life insurance. Life insurance is often the easiest, but the others should be considered if the shareholder is uninsurable. Additionally, alternative funding methods should be included for those triggering events that occur without the availability of life insurance.
When a buy-sell agreement is funded with life insurance, the policy owner (usually a co-owner or the business itself) uses the policy proceeds to buy the disabled or deceased business owner's interest. This ensures that there is sufficient cash when needed to continue the business. Many tax and fairness issues can arise when either the individual owners or the business owns the policy. Using a separate LLC or partnership to own life insurance for buy-sell funding purposes can accomplish the buy-sell objectives without many of the negatives of the cross-purchase or entity purchase methods.
Often overlooked and/or underfunded, the buy-sell agreement is a vital part of the planning for any closely held business. The options are many and the ramifications of the choices are significant. If you do not have a buy-sell agreement in place, commit to getting it done and done properly. If you have a buy-sell agreement currently, regular review is important to make sure it is up to date and will work the way you expect. We welcome the opportunity to help you and your business with proper buy-sell planning.
This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.