Last week we discussed the importance of drafting a will or trust and exit strategy as part of your business plan and that the Purple Rain will fall on you if you don’t plan for your eventual exist from the building. This should be part of your long-term plan to make sure the business is in good hands after you pass away, if an accident befalls you, or when you retire. The natural extension of this planning is the Buy-Sell Agreement.
Buy-Sell Agreements set forth the termination mechanism for a shareholder’s interest in the event of death, disability, business deadlock or transfer. These are all critical questions to address up front in order to preserve and protect enterprise value and I can’t stress this enough: It is in everyone’s best interest for you to draft one.
This ensures that no matter what triggering event arises, you and your partners prepared for them when you all had cooler heads about the state of things. These are legally binding statements that you will need if you want to make sure you or your survivors can cash out.
There are two common Buy-Sell Agreement scenarios:
- The company buys out your shares aka Redemption
Redemption is just for your soul. The business as a unit can purchase your shares. This is a way to cash out. It is called redemption, and is a tax-advantaged strategy. If you die this method takes care of your survivors. Let’s assume you are a co-owner or partner of a business. Any business. If you are on your way out — either due to retirement, death or because of a business gridlock — an agent for the company could make a generous offer for your shares. In this case, you may need a corporate trustee to ensure total neutrality. With a redemption-style agreement, the business itself would make the purchase so the owners don’t go out of pocket. The tax effect of such a buyout is capital gains treatment for a complete liquidation under the corporate tax rules. If those shares are held for more than a year, the long term nature of the capital gains will result in a favorable tax treatment. If you have a Limited Liability Company that is taxed as a partnership, the results are similar, but more complicated in the math.
- Partners buy out each other
Sometimes what starts as a four-partner venture can become a three-person company after a settling-in period. That period is often about a year or so. This could be because things are going well or not well enough. Either way, if the partners feel the business can thrive without you — or you without them — you can recall the agreement that stipulated the terms of a buyout. Such a buyout will result in a mixed tax bag depending on the tax attributes of the shares or the membership units. It could range from short term capital gains taxed as ordinary income up to long term capital gains. On the buy side, the remaining partners will get a basis in the equity that they paid for the shares. This result with either average up or down the basis in the shares.
Either way, my advice is that in most cases you want this to be funded by life or disability insurance. That’s what you have the policy for. This means the business owns the insurance on the lives of each stockholder and then uses the proceeds to buy back the stock in the event of a death or disability.
Contact Brinen & Associates to discuss the best buy-sell agreement for you and your business.