Business owners who have other partners, members, or shareholders need to consider what will happen to their ownership interest on retirement, death, divorce, or permanent disability. The same is true for co-owners of major investment assets such as real estate held in a corporation, limited liability company, or partnership.
A buy-sell agreement might well be the most important document that an owner will ever sign. It is an important part of a business owner’s estate plan because it often creates a flow of cash to the owner on retirement, death, or permanent disability. Each owner needs to consider five major issues before entering into a buy-sell agreement.
- PICK THE RIGHT BUYOUT TRIGGERS
The typical events that trigger the obligation to sell or buy an ownership interest are known as buyout triggers. These typically are:
- Breach of obligations under a major agreement with the entity, such as a failure to make an agreed-upon capital contribution.
But in some situations, certain triggers may not be the right choice. If the entity owns an
investment asset such as an apartment building that has a professional manager, the death,
divorce, or disability of an owner may not be important to the ongoing operation of the asset. It might be just fine if the ownership interest passed to a surviving spouse or children at death.
Another issue: what does the trigger trigger? A trigger normally triggers one of three rights:
- an option of a buying owner to buy out the selling owner’s interest
- an option of the selling owner to force the buying owner to buy out the interest of the selling owner, or
- a mutual obligation on both the buying owner to buy and the selling owner to sell the ownership interest.
Of course, the owner who retires, becomes disabled, or dies wants to know that his or her ownership interest will be purchased. On the other hand, the potential buying shareholder wants to make sure that he or she is not forced to purchase an ownership interest that he or she cannot afford.
- PICK THE RIGHT BUYER
For a key owner of an operating business, picking the right buyer is the most important decision the owner may ever make. The key owner must find a buyer who can successfully run that business in the future. If not, unless the purchase price can be funded with life insurance (which obviously works only on death) or by a loan (which is very hard to do for a small business), the business may not generate enough cash to fund the purchase of the interest.
In a family-owned business, that right person to buy the interest may be a son or daughter. It may be an easy decision if one of your children is in the business and you know that child has what it takes to run the business. But this is not always the case, and it may be necessary to pick only a single child or two and not others to actually have the voting rights needed to make all important business decisions. If a business is a very significant asset in the owner’s estate, it may be necessary to transfer at death an equal interest in the business to each of the owner’s children. To make sure that children who will not have voting control of the business are not squeezed out by their siblings, their ownership interest can be in the form of a nonvoting preferred interest (similar to a long-term note), while the other children who will run the business receive a voting
interest. Another approach is for the sibling or siblings who will run the business to buy out the interest of the other siblings.
- PICK THE RIGHT WAY TO SET THE PRICE
Once the parties agree on the right triggers and buyout parties, a mechanism must be established to set the price of the ownership interest. It is, of course, very difficult to set a price today that will accurately reflect the value of an entity years off in the future.
Buy-sell agreements solve this problem in numerous ways. One is to have the owners set the price each year. This method has a couple of flaws. One is that inevitably, the parties forget to set the price. Or, as often is the case, because of age or disease, it is apparent that one party will die, become disabled, or retire (and be a selling owner) before the other owners (who will be the buying owners). At that point, the selling owner is pushing for a high value while the buying owners want a low value.
A more common approach is to determine the purchase price by an appraiser or by arbitration. The agreement should provide guidance to the appraiser or arbitrator whether the values should be discounted for lack of marketability (unlike Google stock, most ownership interests are not publicly traded, and the appraiser can determine an appropriate value discount) or, if applicable, discounted to reflect a noncontrolling minority interest (if the interest being sold is less than 51 percent). If the ownership interest will be sold between family members and an estate tax might be due, the discounts for minority interest and lack of marketability will reduce estate taxes, normally a positive result. It may not be a particularly positive result, however, if the non-owning sibling will be bought out at a discount or the surviving spouse is left without enough income to live on.
- PICK THE RIGHT BUYOUT TERMS
Setting the right buyout terms is very important. If the price is too high or the terms are too onerous, a buying owner may just not be able to swing a buyout. This is not good news for the buying owner because he or she may end up defaulting on the payment obligation. On the other hand, it is not good for the selling owner either, who will lose the cash flow needed for retirement or to support a surviving spouse.
Typically, buyout terms for smaller businesses tend to favor the buyer. That means lower interest rates, lower down payments, and longer buyout periods. Buyouts are often structured with a small down payment. Perhaps the down payment is the amount of life insurance proceeds, if any, available for a buyout on death, but in no event less than 10 percent of the purchase price. The payout periods are often based on a 20-year amortization with the note coming due in 10 years. This prevents the company from being starved for cash. Some agreements might reduce monthly payments or even eliminate them if the entity’s cash flow is low.
Another issue is whether the purchase price should be secured. If the buyer is the entity, a guaranty of the other owners may be appropriate. Some potential buyers may be unwilling to put their personal assets at risk and may be unwilling to sign a guaranty. Another form of security is a lien against the entity assets. This can be tricky. Often, other financing has terms that prevent placing a second lien on business assets. Even if a second lien can be placed on the property, it may as a practical matter not help the seller if there is a default, since the first lienholder often insists on the right to be paid off in full and the selling owner does not have sufficient cash to do so. Even if that is not the case, the lien may prevent an operating business from obtaining needed operating cash from traditional financing sources, and thus the lien designed to protect the selling owner could cause a default on the payments due to the selling owner.
Generally, except for a personal guaranty, most buy-sell agreements for smaller businesses settle for a lien against the stock, partnership interest, or limited liability company membership interest being acquired.
- PICK A STRUCTURE WITHOUT TAX SURPRISES
Finally, the structure must be scrutinized to avoid tax surprises. Thus, owners need to work through the buy-sell agreement with an advisor who is knowledgeable about tax issues.
Most tax surprises occur when using a corporation. For an S corporation, interests can be held only in certain types of trusts. Shares can never be owned by a nonresident alien or by a corporation, limited liability company, or partnership. An S corporation buy-sell agreement should generally be structured as a buyout by the buying shareholder directly and not by the corporation. This structure creates a higher basis in the buying shareholder. This not only will reduce gain if the stock is ever sold, but will also provide a basis that allows tax losses to pass through to the shareholder in bad years.
For a regular corporation, if it buys the stock of a retiring owner and the other shareholders are also family members, and the selling shareholder continues as an employee or even as a consultant of the corporation, the buyout will be treated as a dividend and not a sale. If it is treated as a dividend, the selling shareholder cannot reduce the gain on the sale (treated as a dividend) by his or her basis in his or her stock. For most regular corporations, it is generally more tax-efficient if the corporation buys out the interest of the selling shareholder. But that is not always the case.
Perhaps the most important action that a business owner will ever take is to enter into a buy-sell agreement. This article touches on just a few of the many issues that may need to be considered. The economic future of a business owner, and of those who depend on him or her, will depend on negotiating a buy-sell agreement that makes sense for that particular business. There can be no substitute for very carefully thinking through these issues with your legal and tax advisors.