Most business-owner clients understand and appreciate the need for a properly drafted buy-sell agreement, but too many still operate without it. Their day-to-day operations relegate such planning to the “back burner.” I have also heard too many times from business partners/co-owners that “when I die my partner will do the right thing.” Maybe so, but at death, the owner of this opinion will no longer be around to balance the relationship and there is typically a lot of money at stake … a time when people get “funny.”

Buyout provisions are best worked out when everyone gets along. That’s the time when parties are in the same bargaining position and a plan can be devised amicably. Often a closely-held business is an individual’s single largest asset and the uncertainty created without an agreement can only bring trouble. After all, the key objective of a well-drafted buy-sell agreement is to create a definite and ready market for a closely-held business interest that might otherwise be very difficult to sell. It limits the owners’ ability to transfer ownership to unwanted persons, usually giving remaining owners or the business entity the “right of first refusal” at a predetermined price before an interest can be passed or sold to an outsider. Certain events such as death, disability and retirement are typical triggers that would contractually obligate either remaining owners or the business to make the purchase. This assures the parting owner will be able to liquidate interests for himself/herself or loved ones.

Planning Considerations

Buy-sell agreements typically come in two flavors — entity purchase and cross purchase — each with advantages and disadvantages. An entity purchase agreement binds the business to purchase interests from a departing owner, whereas a cross purchase binds remaining owners individually. The type of business entity (S-Corp, C-Corp, Partnership...) and the number of owners are key considerations to determine which is best.

If owners individually buy interests from the departing owner, their tax cost increases as it would with the purchase of other assets. Generally when a business is the purchaser, the tax cost of the remaining owners doesn’t change. This however can be overcome depending on the type of entity and other considerations. There is no difference to the departing owner which type of agreement is in place, but the remaining owners could benefit greatly from an increase in tax cost if the business is later sold, reducing their taxable gain.

The more owners there are, the more cumbersome a cross purchase agreement becomes. Often agreements are funded for triggering events such as death or disability by purchasing insurance. Once the options are considered, insurance is typically the most cost effective way to assure liquidity is available when needed. A cross purchase would require each owner to purchase insurance on all other owners. A business with six owners would require 30 policies.

A combination of a cross purchase and entity purchase agreement brings flexibility to whether the individuals or the business will effect the buyout. One party is ultimately bound by the agreement to make the purchase under some triggering events to bring certainty. These agreements need to be drafted carefully. If the language of the document binds the individuals and the entity ultimately makes the purchase, the owners will likely be treated as being relieved of an obligation for tax purposes. This could result in dividend treatment to the owners equal to the amount of the buyout, and commensurate ordinary income tax liabilities that otherwise would have been avoided.

Business relationships are dynamic and sometimes go sour unexpectedly. When one owner wants to leave or oust another owner there is typically less agreement of what the terms and price should be. Buy-sell provisions often lack guidance in this situation. Plans and funding can be put in place to assure liquidation of a party’s interest at death, disability or retirement so we often see the contractual obligations for these triggers. Disharmony among owners is not anticipated by all but a few agreements. An interesting provision often referred to as a push-pull or Russian roulette would dictate that if an owner makes an offer to buy, the potential seller is left with the decision to accept or become the buyer at the same price and conditions in the original offer. This assures an offer will be well thought out and fair because the instigator does not know if he/she will ultimately be the buyer or seller.

For many business owners, a relatively substantial business value creates or otherwise adds to an already taxable estate at death. When an owner dies the business must be valued for form 706, the federal estate tax return and this is often a value challenged by the IRS because of its subjectivity (the higher the value the more tax the IRS ultimately collects). The business is worth what a willing buyer will pay a willing seller neither being under compulsion to buy or sell and both having knowledge of relevant facts. Although the rules are somewhat complex, a properly drafted buy-sell agreement can therefore fix the value of the business for estate tax purposes.

There are several tests to determine whether the agreement is “bona-fide” which are more stringent when dealing with family members but an agreement among nonrelated parties (or nonlineal descendants) typically is considered to be at arms length and would meet the tests. Many business owners have some flexibility in setting the value for the agreement because the value is subjective and they can agree “at arm’s-length” so long as it is reasonable. There is an opportunity here. Many would choose to value the business at the higher end of reasonable to provide greater benefit to heirs and then fund the obligations with insurance. If the value will then be fixed for estate tax purposes this will increase the family tax burden.

Possibly the owners should agree on a lower value, insure it and agree to buy additional insurance (perhaps with company funds) so that family will realize the higher amount at death. For example, two partners may decide the value of a business should be $30,000,000 ($15,000,000 each), the amount they would like to see their families receive at death. There is no absolute value. Even a qualified business appraisal would consider a range of values. After consultation with advisers they agree to implement an agreement that fixes the value at $20,000,000 also considered reasonable, and they insure it with $10,000,000 of life insurance on each of their lives. They place an additional $5,000,000 of insurance each — in an irrevocable life insurance trust — and the business also funds these premiums through bonuses or perhaps a more creative split-dollar arrangement. If properly executed, the end result will be that each family will receive $15,000,000 as they would if the agreement placed such value on the business but only $10,000,000 should be included in the taxable estate potentially saving the family tax on $5,000,000 or approximately $2,500,000 in tax savings after considering both federal and state estate taxes.

A well-drafted buy-sell agreement is an absolute necessity for many business owners, most notably when the intention is not to pass a business to the next generation. It may very well help avoid potentially disastrous, litigious and expensive disputes and could also create dramatic tax savings. Your heirs will appreciate the time you took to decide and plan for the value of the business for both succession and tax purposes, rather than leaving it for the IRS to decide, and if you are on the surviving end of a transition, you may avoid some serious headaches yourself.

David L. Weinstock, CPA, LUTCf is a financial advisor with M&K Financial Services LLC, a wholly-owned subsidiary of Marcum & Kliegman LLP and is a member of Estate Planning Council of NYC. He can be reached at 631-414-4752 or via email at dweinstock@mkllp.com. M&K Financial Services LLC, is affiliated with PartnersFinancial, which is a division of NFP Insurance Services, Inc., a subsidiary of National Financial Partners Corp. (NFP).