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Ask About Buy/Sell Agreements

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By | June 06, 2012

Dear Toolkit,

My brother and I and another business colleague have a small but increasingly successful business. We are all in this for the long haul, but we're somewhat concerned about the welfare of our families if any one of us should die or become disabled. Apart from having the usual life and disability coverage, how can we assure that our families can sell our significant investment in the company to the surviving owners at a fair price in the event of death or incapacity?

Thanks,

Worry Wart

Dear Worry,

Worry not! This is an age-old problem that's easily solved by the use of what's known as a "Buy/Sell Agreement." This tool assures the fair and orderly transfer of ownership interests in a private business, be it a closely held corporation or some form of partnership. The agreement states the terms under which the remaining owners, or even the business entity itself, will buy out your interest. It preserves continuity of ownership and insures that everyone is fairly treated, buyers as well as sellers.

You'll want your buy/sell agreement to include language about how the business is to be valued, how the buy out is going to be funded (with insurance), and under what circumstances you may invoke the agreement. Death is tough to contest, but how disabled must you be to make your partners agree to buy you out?

The agreement can be between the business and its owner (a redemption plan) or among the various owners (a cross-purchase plan.) Frequently, the agreement will be backed by life insurance policies on all the principals, so a ready supply of cash will be there when needed. In a partnership, a buy/sell agreement is like a pre-nuptial agreement between the partners. For corporations, it's an attempt to set future value on some rational basis that may well hold up under IRS scrutiny. The tax benefits of a buy/sell agreement depend largely on careful drafting, so a very good lawyer will be necessary if this strategy is used.

Cross-purchase agreements tend to be a better deal in most cases. To fund the agreement, each owner buys insurance on the life and disability of each of the other owners. The premiums they pay are not deductible, but by the same token, the proceeds aren't taxable either. If there are a lot of owners, it can get a little dicey, but in your case, with three owners, you'd only need six policies in total; (you'd buy one on each of your two partners and they'd do likewise.) If there is a huge disparity in age among owners, the premiums can get a tad lopsided, but that's about the biggest drawback you'd encounter in a cross-purchase agreement.

Redemption agreements, on the other hand, may look like a better deal at first because the company pays all the premiums, owns all the policies, and collects all the proceeds. But if the firm is a C corporation, the proceeds can be subject to alternative minimum tax, the surviving owners' tax basis isn't increased and the proceeds, as well as the cash values, are fair game for any creditors. None of these nasty consequences occur in cross-purchase agreements, which is why they are so much more popular than redemption agreements. Redemption agreements can also create some gnarly estate tax problems too complex to recount here.

Each type of buy/sell agreement has its place, and a good draftsman can anticipate what your needs and problems might be in the future, at the time the agreement will kick in. The valuation formulas are key and need the loving care of a competent attorney and/or CPA. This is not a job for amateurs. Hire the best lawyer you can afford and you'll be assured of getting your money's worth.

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