Abstract: One of the difficulties most family business owners face is determining how, when and to whom ownership interest will be transferred. Even in the best circumstances, the transfer can be difficult because emotions run high and the process is cumbersome. A buy-sell agreement is one tool to help keep the disposition of shares an objective process. This article explores the benefits of buy-sell agreements and how to fund them.
A buy-sell agreement can keep this process objective
by Charles Epstein, CLU, ChFC, Epstein Financial Services
One of the difficulties most family business owners face is determining how, when and to whom ownership interest will be transferred. Even in the best circumstances, the transfer can be difficult because emotions run high and the process is cumbersome. A buy-sell agreement is one tool to help keep the disposition of shares an objective process.
What can it do?
A buy-sell agreement is a contract that sets the price (such as via a formula) at which shares of your business will change hands under certain predefined events, such as:
- Legal incapacity,
- Loss of professional license,
- Bankruptcy, and
Buy-sell agreements are particularly beneficial for family businesses because they create a ready market for shares that would otherwise be difficult or impossible to sell. For instance, when you die, your heirs may be hard pressed to find a buyer for your shares. Rather than being saddled with having to find someone on their own, your heirs would simply go to your former partners or the company to redeem your interest in the business.
A buy-sell agreement can keep business ownership away from “outsiders” by providing the other owners with a right of first refusal and a means to pay for the shares they’re purchasing.
How do you fund it?
Insurance is a common funding vehicle for buy-sell agreements. Here are three types of agreements that use it:
- Cross-purchase. With a cross-purchase agreement, each owner buys life or disability insurance (or both) on each other. At one owner’s death or disability, the other owner collects on the policy and uses the proceeds to buy the deceased or disabled owner’s shares.
For instance, if Judy and Chris are equal partners in a business valued at $2 million, each would acquire a $1 million life insurance policy on the other. If either one passes away, the other would use the proceeds from the life insurance to acquire the deceased partner’s shares. The mechanics are similar if they purchase disability policies instead.
- Most likely, the buyout would be over a period of time rather than all at once. The agreement should indicate the interest rate to be paid on the outstanding amount.
Redemption. Under a redemption agreement, it’s the business — not the individual owners — that buys the insurance on the owners. So the company would acquire the shares of the deceased partner. Going back to the previous example, if Judy and Chris decided to have their company buy the insurance, the survivor would be the 100% owner of the shares because the company would retire the deceased partner’s shares.
Redemption agreements can be particularly beneficial when there are a lot of owners, because many fewer insurance policies are needed than under a cross-purchase agreement.
- Hybrid. This type is a combination of the cross-purchase and redemption agreements. Generally, the agreement would require that the shares first be offered to the business for redemption purposes. If the company were unable to pay for the shares, the other owners would be responsible for buying their former partner’s interest.
How do you pass IRS — and Tax Court — muster?
Like any agreement that may have an impact on tax liability, the IRS may challenge it. Attacks on buy-sell agreements usually come in the form of a challenge to a value listed for estate tax purposes that is derived from the buy-sell agreement. Fortunately, there is an Internal Revenue Code section and a recent court case to guide you.
To design a formula that will pass muster with the IRS, look at Section 2703(b) of the Internal Revenue Code, which states that value as defined for estate tax purposes is valid so long as the agreement:
- Is a bona fide business arrangement,
- Isn’t 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
- Has terms that are comparable to similar arrangements entered into by persons in an arm’s length transaction.
If the agreement fails these tests, the value claimed for estate purposes, by extension, may be challenged by the IRS. There is also a presumption that, if persons other than members of your family own more than 50% of your company’s outstanding shares and the shares of family members and nonfamily members are subject to the same rights and the same restrictions, the buy-sell agreement is in compliance. Although this is a “rebuttable” presumption, it isn’t a conclusion.
Thus, if the IRS determines the buy-sell agreement has no real substance, it can challenge your stated value. If you’re concerned your agreement might not withstand an attack under Sec. 2703(b), understand that the IRS and a court are likely to review the totality of your circumstances.
To help strengthen your contention, negotiate the terms to ensure they’re treated at arm’s length, use professionals to value the business and to determine an appropriate formula for the price, periodically review the formula and adjust as needed, make the agreement while you’re healthy (not when your health is failing) and uniformly enforce the agreement’s terms.
Which one is best for you?
There is no one-size-fits-all buy-sell agreement for everyone because there are numerous factors involved, including your business structure, the company’s financial status, state rules and the needs and circumstances of the individual partners or owners. Although it’s important to have an agreement in place, don’t rush. Otherwise, you and your loved ones may still have a difficult time navigating the sale of shares during an emotional time.
Sidebar: Keep your buy-sell agreement up to date
With a buy-sell agreement, it’s vital to keep everything updated because, as the value of a business grows, a predefined sale price may be well below the company’s true value. Basing a buy-sell price on the business as valued at the time of the transfer is smart, but failing to provide a means for the surviving owners to buy out the former owner (or the former owner’s estate) can be disastrous.
That’s why you need to stay on top of your buy-sell agreement, making adjustments to it when there are ownership changes and ensuring the funding mechanism is in line with the current value of your company.