Business owners who have other partners, members or shareholders need to consider what will happen to their ownership interest in the event of 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 upon 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 retirement, death, divorce disability and, in some situations, a breach of obligations under a major agreement with the entity – such as a failure to make an agreed-upon capital contribution.
Pick the right buyer
For a key owner of an operating business, picking the right buyer is perhaps the most important decision. 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 upon death) or by a loan (difficult for a small business), the business may not generate enough cash to fund the purchase of the interest.
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, difficult to set a price today that will accurately reflect the value of an entity years 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 others (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 appraisal or arbitration.
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 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, because of a loss of cash flow needed for retirement or support of 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.
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 adviser 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 for the buying shareholder. This will not only reduce gain if the stock is ever sold, but also provide a basis that lets tax losses 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 the basis in the 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.
A buy-sell agreement can create a big decision for a business owner. The preceding issues are just a few of the many that may need to be considered. Economic futures will depend on negotiations for a buy-sell agreement that makes sense for a particular business. There is no substitute for careful thinking when navigating these issues with legal and tax advisers.
Ronald Shellan is a partner of Miller Nash LLP. His practice focuses on the intersection of tax and real estate law and includes partnership and LLC law, corporate and business acquisitions, and estate planning. Contact him at 503-205-2541 or at email@example.com.