Most people who have personal assets such as a house, bank account(s), 401(k), CD’s, Stocks, Bonds, cash savings etc. typically have drafted, and keep updated, an Estate Plan with its related components. These components can include a Power of Attorney, a Will, Advanced Directives, Life Insurance, various types of Trusts etc., the objective of which is three-fold: to control, to preserve, and ultimately distribute these assets to their intended recipients in an intentional and tax-efficient manner.
In the end, this allows their Heirs to inherit these assets while minimizing or avoiding altogether what can be huge losses due to taxation at the State and Federal level, as well as potential nasty internal family disputes. Mistakes made in the Estate Planning process can include parties you never intended to receive any of your assets, in fact gaining possession of them.
The root of these avoidable problems is bad planning, or worse, no planning at all.
Your business has the exact same needthe creation of an Estate Plan-your “Business Will”-using a well-crafted and periodically updated, Buy/Sell Agreement. Any business you own or control, regardless of how it is held (C-Corp, S-Corp, LLC, LLP, Sole Prop. etc.) has the same problem e.g., how to maintain control over, preserve, and ultimately distribute, the assets of the company, or portion thereof, you control to the intended recipients at some point in the future. Please understand that it is highly likely in a closely held business that your personal wealth is derived in whole or in part, from the company wealth but many don’t seem to make this connection, often with painful but avoidable results.
This article will not delve into the specifics of Buy/Sell design such as what type of Buy/Sell Agreement should or could be used and the pro’s and cons of each, but instead will center on the Big Picture-why you really need to have a Buy/Sell Agreement in the first place.
In my study of the Buy/Sell arena I encountered some interesting statistics:
- Only 44% of businesses have a Buy/Sell Agreement
- Only 26% of family-owned businesses have a written succession plan
- Only 25% are funded with Life Insurance
- Only 6% of Agreements reflect a current FMV of the business
Design Considerations: There are three areas that need to be addressed in the Buy/Sell Agreement:
1 The type of Buy/Sell format to be employed; these can include the Entity or Cross-Purchase Buy/Sell, the LLC Buy/Sell, One-Way, Trusteed, No-Sell Buy/Sell, Waitand- See Buy/Sell; while I am not an Attorney or tax advisor, one format I have encountered that could be an excellent option is the LLC format when compared to others;
All Agreements will have “triggering” events. This aspect of the Buy/Sell Agreement details at what point it will actually be implemented; triggers that need to be provided for include death, disability due to accident or illness, divorce, personal bankruptcy of an Owner, irreconcilable differences between Owners (the “shotgun” clause), 3rd Party buyout offers, termination both voluntary and involuntary, retirement of an Owner, and personal lawsuits/litigation that could affect the Company;
One area in which the Buy/Sell Agreement can fail is when the definition of disability in the Buy/Sell does not match the definition of disability the Insurer uses in the Disability Policy; common types of disability in a Policy can include Total disability, Partial disability, Residual disability and Presumptive disability; a disparity between the Agreement language and the Policy language can result in no disability benefits being paid when they are needed most;
Some Insurers offer free written reviews of Buy/Sell Agreements I submit to them. While they are not your legal representative of course, they do have deep experience with Buy/Sell Agreements and their reviews are quite good, pointing out both the positive and negative aspects of what they are given to review. Take advantage of this service.
2 Valuation of the company – how to determine a selling price at a given point in time because it will be a fluid figure and needs to be adjusted and tracked; this figure can and will change depending on among other things, the valuation method used;
Some methods to identify a value include using a formula (formula-price agreement) or some sort of accounting standard, hiring an Appraiser or simply agreeing on a number (fixed-price agreement), using Book Value or Adjusted Book Value etc.; please consult your tax advisors for more direction as how this is done because it’s critically important;
Reasons a valuation is needed.
- Sales proceeds could be a source of income at retirement and you need to know what that is Tax impact on all parties
- Effect on family/heirs
- Keeping the IRS satisfied the sale price reflects an appropriate value and is not, for example, unusually low to avoid taxes; for those who’d like to know how the IRS views valuations, refer to Treasury Reg. 20.2031-1(b) and Revenue Ruling 59-60.
3 Funding the Buy/Sell Agreement – sources of money include company capital to fund an Installment sale, a Sinking Fund (often used when an Owner is uninsurable), using future company earnings, savings, Life Insurance, and loans from a 3rd party. Each one should be considered because without a viable funding strategy for the Buy/Sell, no sale can take place.
It’s also important to match the payment obligation(s) in the Agreement with the source of the funds; again, an Agreement that cannot be funded as required, when it’s required, is going to present big problems.
Reasons having a Buy/Sell Agreement makes so much sense.
- To identify Buyer(s) for your interest in the business before a triggering event; if your stake in the company is for sale after a triggering event but prior to having a Buyer, negotiating leverage could be radically reduced;
- Gives minority Shareholders/Owners leverage to sell their interest at a fair price;
- To create an immediate and identifiable market for your share of the company, and equally important, to pre-determine the actual price to sell it for without dispute;
- To provide liquidity to pay Estate taxes;
- To protect your Spouse, Children and other potential heirs;
- To protect your Employees and their families from the risk of the company falling apart after a triggering event that was not planned for but could have been; note that it’s quite possible valuable Employees may quit and move on if they fear the company may collapse because the Buy/Sell cannot be executed due to funding problems, and Employees leaving can in turn, cause serious operational problems;
- Tithout one, Owners could find themselves literally in business with someone they don’t know, don’t like, don’t trust, or has a very different philosophy about the direction the company should go and the risks they should take;
- When an Owner dies, company benefits end; a Buy/Sell Agreement presents an opportunity to fund benefits needed for your family after your departure such as replacing Salary, Term Life Insurance, Long Term Care Insurance, Dental Insurance, Health Insurance, retirement plan contributions etc.; these things can be analyzed and valued by doing a “Benefits Audit”;
- Without a Buy/Sell Agreement, a small business could be forced to liquidate at the Owner’s death or disability, lacking a family member who can and will take over or a sale to an Employee or outsider.
One example of a well-crafted and fully funded Buy/Sell Agreement I provided Life Insurance coverage for involved three brothers in a family manufacturing business; 5 years after placing the insurance on all three, one brother died. As well as the brothers and their spouses got along, the surviving widow didn’t know enough about the business to effectively take her husband’s place, nor did she want to, although technically she was now a full 1/3 partner overnight. The remaining two brothers bought out her interest soon thereafter with all funding necessary to do so via a $1,000,000 Universal Life Insurance policy, based on the terms of the Buy/Sell Agreement, and increased their respective ownership in the business from 1/3 each to ½ each. Everyone knew the route things would take because they did their planning using a Buy/Sell Agreement funded with Life Insurance and were quite satisfied with the result. A true win-win in what could have been a stressful, complex and protracted situation that could have made everyone miserable.
My role in the Buy/Sell Agreement is to review and analyze Life Insurance Policies presently in force, and to design and place new Life coverage when needed. I do not give tax or legal advice. These Policies will likely be either Term Life or Universal Life, depending on the objectives, needs and wants of the parties. It is important that you try to avoid using Captive Agents-this means sales reps who sell for only one company (hence they are “captive”). Captives I have encountered in the past sometimes have a near-fanatical dedication to their company which while admirable, will not likely be in your best interest. It is very important that the sales rep you choose has access to many Insurers because if for no other reason, Premium quotes will vary dramatically, all things being equal. I presently have more than 50 A-rated Insurers I can choose from.
Once significant medical issues present an underwriting problem, it is more important than ever that the Life Insurance rep you work with has the ability to shop your medical file to as many different Insurers as necessary to place the coverage you need for the Buy/Sell. Captives as a rule cannot do this. I do this frequently.
I am completing now a Charitable Giving sale in Rhode Island where the Insured wants to donate a Life Insurance Policy to a private school they attended. The Applicant has some significant medical issues and I took their medical profile to 10 different Insurers for a pre-qualification or PQ. The purpose of the PQ is to get an opinion from the Insurers about what they would actually do before I sent them a Life Insurance application on this person. This is a major time-saver for all involved.
Lastly, please be sure to retain qualified legal and tax advisors who have done this type of work before.
One thing is certain-someday you will leave the business, either voluntarily or involuntarily. Proper prior planning using a well-crafted and fully funded Buy/Sell Agreement will be something you’ll never regret.
