Over 90 percent of the businesses in the United States are closely held (nonpublic). More than two-thirds of those are family owned and controlled. Unfortunately, approximately 70 percent of them will not survive past the death of their founder, and 85 percent will not survive past the death of the next generation. Yet, only 30 percent have any business continuity plan, and one-third of those plans are not in writing. The majority of businesses that do have a continuity plan (buy-sell agreement) have one that is outdated.
A buy-sell agreement performs many functions during the lifetime of a business. Properly structured buy-sell agreements between relatives in a family owned business assure a smooth transition of ownership. In general, the buy-sell agreement is the crux of a business’ continuation plan and the owner’s estate because it controls who can or must buy a departing owner’s share, the events that will trigger a buyout and the price that will be paid upon an owner’s exit (whether voluntary or involuntary). In effect, the buysell agreement serves as the business’ will.
A buy-sell should address voluntary and involuntary conversions, including: death, disability, retirement and buy-outs, divorce, bankruptcy and irreconcilable partner disputes, as well as allowable transfers of ownership. With each of these instances, a method for valuing the business interest must be stipulated, and sufficient funding and/or liquidity must be available to satisfy the interest buyout. A buy-sell also provides minority shareholders a market for their otherwise illiquid stock. Even sole owner businesses need an agreement in place to facilitate the ease of their retirement or address business issues in the event of their death. In the case of a sole business owner, the other party to the buy-sell agreement might be a key employee, another company within the industry or a major supplier or customer.
Valuation
Some owners elect to value their business below fair market value in their buy-sell agreement, thinking this will reduce their estate tax liability. In doing so, they fail to consider that a buy-sell agreement price is binding for estate tax determination only if it meets three specific conditions and complies with IRC Section 2703, where applicable. If these criteria are not met, the IRS can reject the value for purposes of determining the estate tax due and, in a worse case scenario, the heirs may end up owing the IRS more in estate tax than they received from the sale.
A buy-sell agreement must be updated regularly to ensure its provisions adequately address current business circumstances and the present value of the business interest. The services of an accredited business valuation expert should be engaged to ensure an accurate valuation is performed that is compliant with IRC Section 2703 and, therefore, binding upon the IRS for purposes of estate tax calculations.
How often should the valuation be revisited? Absent any substantial changes in business structure, ownership or ownership intent, a valuation should be done approximately every two years, depending on the nature of the business and change in profits. In the event there is a change in structure, ownership or ownership intent, or a substantial sustainable increase in profits, the valuation should be updated immediately subsequent to that event. Remember, the value of the business interest determines the type and extent of the actions required to minimize tax consequences and ensure execution of ownership intent.
The IRS audits nearly 100 percent of deceased business owners’ estates. Therefore, proper planning must anticipate, and provide for payment of, any federal estate tax due upon the death of an owner. If the business interest is undervalued, the decedent’s estate could be penalized by the IRS for reporting a value less than fair market value; conversely, if the value stipulated in the agreement is in excess of fair market value, the heirs would be subject to unnecessary taxes.
Funding
A buy-sell agreement that does not have a secure source of funding is largely ineffective and of diminimus value. The agreement should provide for adequate capital, or an agreed upon payment structure, to fund a purchase upon a triggering event (i.e., death, divorce, disability, other voluntary or involuntary exits, etc.). A preferable funding vehicle is a quickly liquid asset, such as key man insurance or marketable securities.
A business is not static—sales, product lines and clientele are ever-changing, all of which directly affect a business’ value. Life circumstances also change (i.e., marriage, divorce, children, etc.). Therefore, the buy-sell agreement and the valuation must be updated on a regular basis to ensure the agreement provides for adequate funding vehicles to support the value of the business and ownership interests.
