Any business that has more than one owner has an opportunity to use contract law to create expectations for how the business will operate in the event of major life transitions for its owners. All businesses spend time planning how they will generate revenue to maintain their existence. Most businesses even plan for catastrophe through the purchase of a variety of insurance products that can prevent the failure of the business if certain things occur. Many businesses are missing the chance to address several lifetime events that could dramatically affect the operation of the ongoing business. These events are many times a virtual certainty, such as death or retirement, and therefore taking the time to plan should not be perceived as being overly cautious, but rather simply an exercise in prudent long-term business planning.
Many advisors will suggest that executing a buy-sell agreement to create mechanisms to deal with issues such as death, disability, retirement, bankruptcy, forced buy-out, etc. is best done as soon as the business is formed. This advice certainly has credibility and yet is problematic. It is best to draft at least some form of buy-sell agreement to address as many issues as possible early in business operations. However, this document should not be set aside and forgotten until a triggering event occurs. Rather, it would be most useful to review the agreement once a year in the first several years of business operations. If the business is viable, it will grow rapidly in the first few years and decisions made at the outset of operations may make little sense as the business begins to function at a more complex level. Ideally the agreement will be regularly reviewed by the business owners as long as the business continues to function.
Drafting of a buy-sell agreement is essentially a game of “what if?” Discussions regarding what happens when a partner dies, wants to retire, wants to sell his or her ownership interest to an outside party, becomes disabled and cannot continue to contribute to the business in the same way, gets divorced, or files bankruptcy, can all be addressed in the buy-sell agreement. There are endless options for how to deal with each situation and the partners in the business have the opportunity to come to a consensus of personal preference in the contract.
Probably one of the most powerful aspects of the buy-sell agreement is the ability to address the practical issue of funding. Many authorities will suggest that a buy-sell really only works if the instrument is “funded.” In other words, if a partner is required to sell because of certain triggering events, the other partners or the business itself may or may not be able to acquire lending to fund the transaction. The buy-sell agreement creates the opportunity to address this situation by allowing the parties to draft the ability of the buying partner to utilize the selling partner as the lender. The selling partner may be put in a position, either because the buying partner can’t get financing or simply because the agreement calls for the selling partner to providing the financing, to carry a note for payment of the value of the ownership interest. Depending on the circumstance, the parties may not be able to come to an agreement of this sort at the time of the triggering event. The buy-sell effectively acts as pre-nuptial agreement of sorts in that disagreeing owners have made decisions with “cool heads” at contract drafting time, rather than in the heat of a potentially problematic situation. There is no doubt that this creates a beneficial situation for all concerned.
Other funding options may involve the purchase of life or disability insurance that could provide the cash necessary to fund a buyout based on the triggering events of death or disability. A variety of tax and legal issues are associated with the purchase of these insurance products, but all of these issues can be addressed with legal and accounting counsel at the time of drafting to determine what is in the best interest of all contracting parties.
The buy-sell agreement can also be an opportunity to set a value on the ownership interest at the death of an owner for estate tax purposes. If sales of ownership interest will be to family members at death, there will be heightened scrutiny by the IRS of the valuation placed on the ownership interest. Nevertheless, if planned properly, the valuation portion of the buy-sell agreement can have a beneficial effect for estate tax purposes.
If you require a review of your existing agreement or would like to discuss the drafting of a buy-sell agreement for your business, please don’t hesitate to contact us.