Agree Now, Avoid Headaches Later

October 3, 2016

It’s easy to get caught up in the day-to-day tasks of running your business and to put off thinking about the future. But every business needs a plan.

A buy-sell agreement is a great tool to help you and your fellow business owners deal with some difficult issues that may come up in the course of running a business. This type of agreement provides for the sale of an owner’s interest in case of death, disability, retirement, an offer to purchase the interest from an outside party, or the divorce of a partner.

Having a buy-sell agreement assures the departing owner (or the family) that there is a guaranteed buyer who will buy the business at a fair price. The buying shareholders benefit because the agreement enables them to continue the business without having to negotiate with outside parties. Buy-sell agreements can be drafted to accomplish the following:

• Set a fair price for valuing the stock that is to be transferred

• Determine the procedure to be followed when a triggering event occurs, such as retirement

• Give the right of first refusal to the other shareholders, to maintain continuity of the business

• Provide funds or an income stream to the business owner’s survivors

A buy-sell agreement, however, does not guarantee that the other shareholders or key employees will have the means to purchase the stock. So, you may want to fund your agreement with life and disability insurance. In this case, either the company purchases life insurance on all of the shareholders or the shareholders purchase life insurance on each other. The proceeds, which are generally tax free, are used to purchase the decedent’s stock. Unfortunately, the business cannot deduct the life insurance premiums.

If you operate as an S corporation, it’s even more critical to have a buy-sell agreement, which can prevent an owner from selling an interest to a nonqualifying shareholder that would nullify the S corporation election. It is important to make sure that your buy-sell agreement treats all owners equally and that its provisions are followed. Preferential rights, both within the agreement or as a deviation from it, could constitute a second class of stock and, thus, could nullify the S election: an S corporation can have only one class of stock.

Buy-sell agreements can help ensure a smooth transition when a partner departs from a closely held business. As you think about your plan, structure an agreement that meets the needs of the company and the shareholders and their heirs.