Proactive planning and attention to detail are vital to the buy-sell agreement
Succession tool ensures smooth and equitable transition after a triggering event.
July 9, 2012
Many of our clients make the choice to have one or more partners involved in their business venture(s). They may have created the partnership based on a shared vision in the blissful early stages of forming a new entity. Other partners may have come on board later in the business cycle, when hard-charging employees were rewarded with a buy-in opportunity. Partners may have also been added based on a need to infuse capital into the business. In every case, all partnerships need a buy-sell agreement to cover triggering events such as:
In a succession planning context, the objective of the buy-sell agreement after a triggering event is to make sure that business ownership ends up in the hands of the intended person(s) and that the transaction is equitable to all concerned.
Issues addressed and types of agreements
Most CPAs are familiar with the key buy-sell agreement issues. These include the approach used to establish the value of the business (with some agreements including a stipulated purchase price), payment terms, transfers of ownership both permitted and prohibited, how funding of the buy-sell works, and any noncompete requirements that may apply after a sale of the business.
Common types of agreements that take effect in the event of death or disability are cross-purchase and redemption agreements. A cross-purchase arrangement obligates another owner to purchase the departing owner’s interest at the point of death or disability, with the most typical funding mechanism being a life insurance policy. This approach can work well if the number of owners is not so large as to create a complex web of who is required to buy out whom. The cost of life insurance is often quite reasonable unless owners are unhealthy or at advanced ages. Assuming life insurance premiums have been paid for by the policy owners/business partners personally using after-tax dollars, the proceeds are not taxable to them and can be used to purchase the interest from the decedent’s estate.
The other common structure for buy-sell arrangements is redemption of ownership by the business. Here, the funding is an obligation of the business, and the purchase transaction is not a tax-deductible transaction, although any interest paid (assuming the purchase takes place over time and is secured by an interest-bearing note) would be deductible. Of course, insurance can be used to create a pool of money to fund a redemption arrangement, too (however, there can be some issues with the alternative minimum tax in certain situations). The other important thing to note is that as a result of the redemption, the respective ownership of the remaining owners will change—something that needs to be managed in line with the succession plan objectives.
Some combination of these two approaches is sometimes used whereby the business may have the first right of refusal to buy the interest and the other owner(s) may have a second option to buy out the ownership interest.
Getting it right
The buy-sell concept is a very good one to control who ends up with ownership as well as to protect the interest of the exiting owner or his or her estate. The devil is in keeping the details current and relevant. I have seen situations in which the surviving partner thought that he or she had the buyout of his or her deceased partner covered by life insurance through a cross-purchase/redemption arrangement, only to discover that the beneficiary of the policy was the deceased partner’s spouse rather than the business. As a result, the business, essentially, had to pay twice for the deceased partner’s interest—the first time for all the insurance premiums that had been paid out of the business’s cash flow and the second time through a series of installment payments made out of business cash flow.
Lack of attention to detail can also lead to these common situations:
Banks are not typically fond of funding redemptions, since it basically amounts to an extraction of capital from the business with no prospect of a return on investment.
The examples I’ve shared in this article illustrate why proactive planning and attention to detail are vital to having the buy-sell agreement serve the intended purpose of getting ownership in the right hands under equitable terms.
Maybe your clients avoid succession planning because it’s complicated and fraught with the danger of making mistakes. Thank goodness they have CPA advisers like you to manage the details. In my next article, I’ll discuss how certain types of trusts can play a great role in succession planning for your clients.
**The AICPA’s PFP Section provides information, tools, advocacy, and guidance to CPAs who specialize in providing tax, retirement, estate, risk management, and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP Section. CPAs who want to demonstrate their expertise in this subject matter can learn more about the Personal Financial Specialist (PFS) credential.