Sunday, September 6, 2009

Buy-Sell Agreements: Planning for a Business Owner's Death

In 1968 high school friends Sam and Larry started their plumbing supply business, Drainco Plumbing Supply, Inc., with the modest goal of providing a nice life for their growing families. Through hard work and good business sense, by 2009 Drainco Plumbing Supply – which now employs 35 people, including one of Sam’s sons and one of Larry’s daughters – has grown to be worth $10 million.

But Sam and Larry’s success comes with strings attached. Like most owners of successful closely-held businesses, the value of their business interests is by far their largest asset. Since the asset is illiquid, a premature death can prove disastrous, as the owner’s estate will need to pay what might be a substantial federal and New York State estate tax – in cash -- within nine months of the owner’s death. If there is insufficient cash to pay the tax, either the estate will need to sell the deceased owner’s interest in the business at a “fire sale” price, or pay the tax late with substantial penalties and interest. Tax issues aside, without planning a partner’s unexpected death may create a situation where the remaining owner is now a partner with the deceased owner’s widow, who may well have no experience with, or interest in, the business.

To ensure the preservation of the equity of their business as well as their legacy, business owners must plan ahead for the inevitable day when they will “leave” the business – whether vertically or horizontally!

All closely-held businesses should have a formal plan to ensure the preservation of the business upon an owner’s death. The Buy-Sell agreement is the planning tool used to provide the “road map” to address various contingencies such as the death, disability, or retirement of an owner, and those circumstances (if any) when an owner can sell their interests in the business to a third party.

Sam and Larry need to take time from their busy schedules and sit down with their attorney, accountant and insurance professional to devise a strategy to address the various life events that are part of any solid Buy-Sell agreement. A fundamental component of any Buy-Sell agreement is inclusion of a mechanism to provide for the disposition of an owner’s business interest upon death. A common scenario would be for Sam and Larry to purchase life insurance on each other’s life in a cross-purchase arrangement, with a death benefit equal to at least the value of each owner’s interest in the business. Since closely held businesses are often difficult to value, Sam and Larry are well-advised to use a business valuation specialist to determine the business’s actual value so that the appropriate amount of insurance can be purchased.

In a cross-purchase agreement, each owner is contractually obligated to purchase from the deceased owner’s estate (or trust, if applicable) the deceased owner’s interest in the business. In the event of Sam’s death, the business would need to be valued to determine the value of Sam’s interest in the business at the time of his death. Larry would use the life insurance proceeds from the policy he owns on Sam’s life to purchase Sam’s interest in the company from Sam’s widow, Sarah. If the life insurance is insufficient to pay the full amount of Sam’s interest in the company, the agreement should provide a mechanism – typically in the form of payments over a period of years pursuant to a promissory note, secured by Sam’s stock – to pay the balance of the purchase price to Sarah.

To help prevent a scenario where too much of the purchase price must be paid for via installment payments, it is critical that the owners’ assess their company’s value periodically, and increase the amount of life insurance on each other’s lives if feasible.

In businesses with three or more owners, it may be unwieldy to use a cross-purchase arrangement, as each owner would need to own a policy insuring the life of each other owner. An alternative to the cross-purchase arrangement is a redemption agreement in which the business entity (i.e., the corporation, LLC, etc.) is the owner of the insurance policies insuring the lives of each owner. Upon the death of an owner, the entity uses the life insurance on the deceased owner’s life to purchase from his or her estate the deceased owner’s business interest. For example, assume Drainco Plumbing Supply has a third shareholder, Kurt, with each shareholder owning 33 1/3 of the company stock. Upon Sam’s death, Drainco Plumbing Supply would purchase Sam’s stock from his estate. Larry and Kurt will now each own 50% of the remaining issued and outstanding stock in Drainco.

A third alternative is the hybrid, or wait and see arrangement. In a hybrid Buy-Sell agreement, the corporation has the first “option” to purchase a deceased shareholder’s stock. If the corporation does not exercise the option, then the remaining owners will have the option to purchase the deceased owner’s stock. If the individual shareholders do not exercise the option, then the corporation will typically be required to purchase the stock.

The hybrid agreement has gained greater usage over the past few years, as it affords greater flexibility to address the different tax impact of a corporation’s purchase of an owner’s stock as opposed to a purchase by the individual shareholders. Regardless of the structure used for the agreement, competent tax assistance is a must to ensure the best results.

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