Does your company have a buy-sell agreement? If not, it should. These binding contracts determine how — and at what price — ownership shares of a business will change hands should an owner depart for any reason.
But even if you have one in place, it’s important to buy in to both the concept and finer points of the agreement itself. Like an insurance policy, a buy-sell isn’t exactly a thrilling read. But you need to fully understand all of its ramifications.
A buy-sell sets up parameters for the transfer of ownership interests following any of a number of stated “triggering events.” These include an owner’s death or long-term disability; loss of license or other legal incapacitation; retirement; bankruptcy and divorce.
The agreement will also specify a valuation method for appraising the departing owner’s interest at the appropriate time. In choosing a method, you and your fellow owners need to carefully define buyout terms and specify the financial data to be used in the agreement.
For example, a sound buy-sell will spell out a required end date for the financial statements that must be used to appraise business interests following a triggering event. Some also mandate a particular level of assurance — compilation, review or audit — regarding those financial statements.
An additional and often overlooked point about valuations: They take time. Business owners are often surprised at the amount of research and review involved in the process. And this can occur under difficult circumstances if, say, an owner has suddenly passed or a severe conflict has developed.
CRITICAL FOR CLOSELY HELD COMPANIES
Closely held businesses that fail to create a viable buy-sell agreement, or fail to create one at all, put themselves at particular risk. Unlike public companies, private ones have no ready or established market in which to sell ownership shares. Also, comparable businesses may be hard to come by and buyers may simply not exist.
These points can create difficult circumstances for businesses, especially when something unexpected happens. Say an owner suddenly dies. His shares may pass on to his heirs, but how much are those shares worth and to whom can his heirs sell them?
In contrast, a buy-sell will remove uncertainty by stipulating that remaining owners will buy the ownership interest at a price determined by the stated valuation method. Plus, the agreement will help to prevent an unfamiliar and perhaps unwanted owner from suddenly joining the business.
In many cases business owners don’t have the cash readily available to buy out a departing owner. So most buy-sells include an insurance policy to fund the agreement. And this is where several different types of agreements come into play.
Under a cross-purchase agreement, each owner buys life or disability insurance, or both, that covers the other owners. Should one owner die or become incapacitated, the other owners collect on their policies and use the proceeds to buy the deceased or incapacitated owner’s shares.
Another type is a redemption agreement. Here the company — not each owner — buys the insurance policy and acquires the deceased or incapacitated owner’s shares. This approach can really help businesses with multiple owners because fewer policies are needed.
In some cases, a company will create a hybrid buy-sell that combines aspects of the cross-purchase and redemption approaches. These agreements may stipulate that the business gets the first opportunity to redeem ownership shares. And if the company is unable to buy the shares, the remaining owners are then responsible for buying the departing owner’s interests. Alternatively, the owners may have the first opportunity to redeem the shares.
SPECIAL NOTE FOR C CORPS
If your company is structured as a C corporation and has a redemption agreement funded by life insurance, you’ll need to pay extra attention to potentially adverse tax consequences.
First, receipt of insurance proceeds could trigger corporate alternative minimum tax. Second, the value of the remaining owners’ shares will probably rise without increasing their basis. This in turn could drive up their tax liability in the event they sell their interests.
Heightened liability for the corporate alternative minimum tax is generally unavoidable under these circumstances. But you may be able to manage the second problem by revising your buy-sell as a cross-purchase agreement. Under this approach, owners will buy additional shares themselves, increasing their basis.
Naturally, there are downsides. If owners are required to buy a departing owner’s shares but the company redeems the shares instead, the IRS may characterize the purchase as a taxable dividend. Your business may be able to mitigate this risk by crafting a hybrid agreement that names the corporation as a party to the transaction and allows the remaining owners to buy back the stock without requiring them to do so.
This has been a general discussion and is not intended as advice. Because buy-sell is a complex agreement, it is advisable to seek the assistance of qualified professionals.
Norman G. Grill is a certified public accountant and managing partner of Grill & Partners, LLC, CPAs and advisers to closely held companies and high-net-worth individuals with offices in Fairfield and Darien. He can be reached at N.Grill@GRILL1.com or 203-254-3880.