The Business "Prenuptial" and Avoiding the Manure
Last week I was visiting with prospective clients who own a national business based in Texas. When I think of Texas, I think of longhorn cattle that leave behind a by-product that you don’t want to get on your boots. How does that tie in with buy-sell agreements? These prospective clients just spent a great deal of money and time creating a stock redemption buy-sell agreement (see below) and didn’t see the tax manure they had just “stepped in”. With that in mind, let’s have a conversation about the different types of buy-sell agreements and some potential issues.
A buy-sell agreement can be thought of as a “prenuptial agreement” for the business. It establishes what happens if a co-owner leaves the “business marriage.” It can be used for nearly any type of entity, i.e., a corporation, limited liability company or partnership, and is crucial, and commonly underutilized, for businesses with two or more owners.
Buy-sell agreements must be carefully drafted to take into account unique circumstances. While this article will discuss a few of the many issues that are involved in buy-sell agreements, you should seek guidance on the specifics of your situation and the actual drafting of your own agreement.
Bottom-line: There Are Three Primary “Flavors” of Buy-Sell Agreements
- Cross-Purchase Agreements – the remaining co-owners are required to purchase a departing co-owner’s interest.
- Stock Redemption Agreements – the business is required to purchase a departing co-owner’s interest.
- Hybrid Agreements – the business is required to purchase a departing co-owner’s interest, but only if the surviving co-owners opt not to.
Each type of agreement has its own advantages and disadvantages. In general, a cross-purchase agreement works better when there are only two or three owners. If there are more than three owners, a redemption agreement, although generally not as beneficial tax-wise, may be easier to manage.
What Would Typically Trigger the Buy-Sell Agreement?
The buy-sell agreement usually outlines various triggering events that give the owners of the business or the business itself the option to buy out the interest of another. Triggering events can include: disability, death, retirement, divorce, bankruptcy of a co-owner, termination of employment, loss of a professional license (if applicable), a falling out between the co-owners, or receipt of an offer by a third party to purchase an owner’s interest in the business.
How Do We Come Up With A Purchase Price?
The owners can choose from a number of possible ways to determine the future value of the business:
- The fixed price approach – the co-owners agree on a fixed sales price and periodically reevaluate and reset the price. (Drawback: Often, owners never come back to re-visit the price and it becomes outdated.)
- The book value approach – the price is determined by adding all assets of the business and deducting all debts and liabilities. (Drawback: Although simple, this does not usually reflect the fair market value of the business.)
- The fair market value approach – the price is based on the business’s likely sale value on the open market. (Drawback: Fair market values are more difficult to obtain for privately held businesses unless utilizing the services of an outside appraiser. See below.)
- The formula approach – a predetermined formula is used to establish the business’s value. (Drawbacks: Formulas are less flexible and since they are “generic”, they seldom fit the many differences in industry, circumstance, profitability, etc.)
- The bona fide offer approach – the price is determined by the amount of a bona fide offer that the business actually receives for the departing owner’s position. (Drawback: Is the offer fair and reasonable? Compared to what? While attractive as a quick remedy, in a vacuum, it is difficult to know if an offer is reasonable.)
- The multiple of earnings approach – the price is set as a multiple of earnings over a period of time. (Drawback: Service businesses have a different multiple than other types of businesses. Typically, the greater the sales volume, the higher the multiple … but how to decide?)
- The outside appraisal approach – a qualified business appraiser determines the business’s value. (Drawback: This ordinarily gives the best results, but it doesn’t come for free.)
The determination of the purchase price is critical to the harmony of the business. While a meager purchase price is unfair, an exorbitant purchase price gives the departing co-owner a windfall; and either scenario can lead to litigation. The solution is to find a procedure that ensures a fair price for all parties involved. As stated above, the outside appraisal approach is often best since it results in the most accurate valuation of the business when a triggering event occurs.
Where Does the Money Come From?
Financial risk associated with the disability or death of a co-owner can be minimized by obtaining disability and life insurance.
- Under a Cross-Purchase Buy-Sell Agreement, each owner buys a disability and life insurance contract on the other co-owners; upon the disability or death of an owner, the remaining owners receive the benefits from the insurance policies to buy out the disabled/deceased owner’s interest in the business. A variation of this approach would be to create an irrevocable trust to purchase a single contract on each owner. Upon death or disability, the funds flow into the trust. This increases the cost basis for each surviving partner, but usually lessens the number of contracts that need to be purchased.
- Under a Redemption Buy-Sell Agreement, the business purchases one disability and one life insurance contract for each owner*. Upon the disability or death of an owner, the business receives the insurance proceeds and uses it to buy out the disabled/deceased owner’s interest in the business.
Other triggering events that cannot be dealt with by insurance can be paid in cash or in installments over time pursuant to a promissory note.
- Cash – retained earnings, bank loans, and current cash flow may all be used to buy out a departing owner’s interest in the business or to pay out their ownership interest in installments over time.
- Promissory note – the promissory note may be guaranteed by the remaining co-owners or the note could be secured by the assets of the business.
* Insurance Owned by a Business
Since 2006, life insurance owned by a business requires special handling. There is a letter which must be signed by each insured with four distinct points in order to keep life insurance proceeds from being treated as ordinary, taxable income. In addition, the business must file tax form 8925 for each tax year the contract(s) is/are inforce. Unfortunately, few insurance agents or CPA’s are aware of these requirements and the necessary tax form to be filed. As a result, a number of businesses will pay needless amounts of tax on normally tax-free life insurance proceeds.
Who would have thought that a concept that seems so simple could become so complicated? If you have any questions or would like a complimentary review of your current (or prospective) buy-sell agreement, give our office a call at (800) 975-5355. We turn the “complicated” into “understandable and actionable”.
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Written by R. J. Kelly