Five musts for buy-sell agreements

Fifty-three percent of family business owners have a buy-sell agreement. Are you one of them?

A buy-sell agreement can protect your business against many unexpected events. When preparing your buy-sell agreement, there are several things to consider, whether you use a redemption or cross-purchase plan.

In a redemption agreement, the business agrees to purchase the shares from an owner. In a cross-purchase agreement, the other owners agree to purchase shares from a departing owner.

Regardless of the type of buy-sell agreement you choose, you want the greatest flexibility possible to accommodate changing circumstances. Generally, the best way to ensure flexibility is to give the business the right of first refusal to purchase the departing owner's shares. If the entity doesn't exercise its right, the remaining owners can complete the purchase. This type of agreement allows you to see whether a redemption or cross-purchase plan is better.

Finding a method for establishing a price

Establishing a price for a family business is difficult because there is usually no ready market for the shares and no comparable sales. Also, family business owners who want to transfer their interest to their children may be more concerned about avoiding estate taxes than in establishing fair market value.

Three methods often used in buy-sell agreements for establishing price are: 1. Independent appraisal, 2. Formula, and 3. Agreed value.

If the valuation for the buy-sell agreement will also be used for estate tax purposes, the buy-sell agreement should be a bonafied, arms-length agreement based on an appraiser's determination of fair market value.

When the formula method is used, a price can be determined annually by applying the formula. Because of the simplicity of this method, the parties involved need to discuss whether the formula will hold up year after year. Sometimes buy-sell agreements have been in effect for many years with archaic formulas that are no longer meaningful.

When an agreed value is used, provide a default valuation in case the parties can't meet at regular intervals to review the agreed-on value. Usually that default value will be the prior value, adjusted for financial results for that time period. A drawback to this method is that when parties are related, the IRS may not honor the established value.

Funding the buyout

If the buy-sell agreement provides for the payment of a buyout caused by a triggering event, be certain that the party handling the buyout can make that payment. Lump sum payments are sometimes required, especially on an owner's death.

Life insurance is the most common form of funding a buyout of a deceased owner. If a cross purchase is contemplated with more than two shareholders, several insurance policies on each person will be necessary, because each owner must own a policy on one another's life.

In a redemption agreement, you need fewer policies, because the business entity requires only one policy on each owner's life. If a C corporation funds insurance on a redemption basis, the corporation may be subject to the alternative minimum tax (AMT) on the collection of insurance proceeds. Using a family partnership or trustee buyout as an alternative can reduce the number of policies needed and accomplish a buyout without the AMT risk.

When a buyout occurs on an event other than a death, providing for installment payments with interest over a period of time is advisable. This allows the buyer to secure financing or to fund the buyout through company earnings.

In a disability buyout purchasing disability insurance is appropriate for two reasons: 1. The insurance company, as a third party, can arbitrate whether an individual is disabled, and 2. The insurance company can provide some or all of the funding of the buyout upon disability.

Triggering events

Typical triggering events are death, disability and termination of employment, but other events may be included as well, such as an owner being convicted of a felony, embezzlement, fraud or any other act that discredits the company. In fact, some buy-sell agreements have "bad boy" clauses. When a bad-boy clause is triggered, the buyout amount may be very low.

Conclusion

How you structure your buy-sell agreement depends on many varying factors. Once your agreement is in place, it should be reviewed periodically to ensure conformity to current IRS regulations.

If you would like assistance in structuring or reviewing your buy-sell agreement, please call us.

Melvin J. Van de Ven, CPA, CVA is a partner in the certified public accounting firm of Schott & Van de Ven in Cape Girardeau. He can be reached by email at mvandeven@schottvandeven.com.