My client handed me his 13-year old buy-sell agreement. The business value, specified as a fixed amount, was about
3 percent of the current market value. Any problems here? First, the value is not current and too low. Attempts to enforce the contract would result in litigation. Second, the IRS will not accept the low value for estate tax purposes. Third, since this agreement is not current, the funding for the buyout does not exist. Either the buyer or the company must come up with funding or it’s very likely all or part of the business will have to be sold to a third party.
There’s more. The remaining owner will be at odds with his partner’s family. Why is the buy-sell agreement (Agreement) so important? This document spells out how ownership of the business will be transferred in the event of death, disability, divorce, departure (retirement or otherwise), deadlock, default or disagreement. The Agreement also must address the determination of value of the business and any other circumstance the owners foresee and wish to cover.
Death of a Shareholder
Financial distress and leadership void usually follows the death of an owner. This problem may be compounded if the surviving shareholders have no choice but to take in the inexperienced new partner/spouse who will expect a salary and profits from the business to maintain lifestyle. The Agreement should set the process for determining the business value. A harmonious transition of ownership can occur when the Agreement fully funded. Life insurance is generally the best solution.
Disability of a Shareholder
Agreements ignoring funding of or poorly defining disability can be a severe cash drain. Burn this into memory: it is critical that the definition of disability within the Agreement match the definition of disability income within the disability insurance policy. If not, the Agreement may call for payments where the disability income policy is not required to pay.
Divorce of a Shareholder
In a divorce, a spouse often ends up with one half the business interest of a closely-held business. Needed are provisions requiring the spouse to sell stock back to either the: (a) corporation; (b) original shareholder; or (c) other shareholders. The price cannot exceed the fair market business value.
Departure, Deadlock, Disagreement, Default
Other important issues that should be addressed in the agreement as well.
Determination of Value
The most important provision in a buy-sell is the valuation of the business. The value must satisfy both the owners and not circumvent valuation for IRS purposes. If not, plan on paying legal fees.
Imagine your expertly crafted, but unfunded buy-sell agreement sitting on your shelf; it is barely worth the paper it is printed on. The best funding mechanism is insurance. Insurability is an undisclosed asset on your personal balance sheet.
This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances.
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