As we discussed in our first blog post on buy-sell agreements, these often overlooked documents are critical for businesses with more than one owner. Although a simple buy-sell agreement will suffice for most businesses, there are a few key elements that all should include.
Here’s what you should include—and consider—when drafting your buy-sell agreement.
There are three types of buy-sell agreements:
- Corporate redemption. In this agreement, the corporation has the first right to buy shares of the departing shareholder.
- Cross-purchase. This agreement gives shareholders the first right to buy shares of the departing shareholder.
- Combination. As you might have guessed, this type combines the attributes of the corporate redemption and cross-purchase options. Typically, the corporation has the first right to buy the shares. Any remaining shares (i.e., that the corporation did not purchase) may be bought by other stakeholders. This combination allows you to customize the agreement, giving you flexibility to get the results you want.
This is usually the hardest part of drafting a buy-sell agreement. There are four basic methods you can use to determine pricing.
- Fixed price. The agreement states a fixed price per share.
- Formula. The price is determined by a predetermined formula.
- Outside appraisal. The price is determined by an outside party at the time of purchase.
- Shareholder set. One shareholder sets the price and the other shareholders can determine whether they will buy or sell at that price.
Depending on your situation, any combination of these four may be appropriate. For example, your price may be financial statement equity (formula) plus the excess of the appraised value of the equipment as determined by an outsider appraiser (outside appraisal).
For insights into which method is best for your buy-sell agreement, check out this JAK + Co. blog post on valuation concepts.
What events should trigger your buy-sell agreement? Typically, triggering events include retirement, death, bankruptcy, or disability of a business owner.
The redemption may be funded several ways:
- Life insurance proceeds. The redemption is funded through a life insurance policy. This is best when the redemption is planned upon death of a shareholder.
- Borrowing. The company or shareholder borrows funds from outside sources to fund the transaction.
- Installment sale. There is an agreement to pay the leaving shareholder or their estate over a period of time with interest. In essence, it’s borrowing the funds from the departing shareholder.
With proper planning, a buy-sell agreement gives you the opportunity to determine your company’s value for estate and gift tax purposes. The IRS recognizes the pre-established price of a buy-sell agreement as the value for estate purposes if certain criteria are met.
Type of Entity
The business structure is particularly important to the agreement. For example, if you own an S corporation or professional partnership, you’ll want a clause in the agreement to prohibit ineligible shareholders or partners from acquiring interests in the business.
Once your buy-sell agreement is in place, review it periodically to make sure it continues to meet your needs. For example, pricing mechanisms that were valid five years ago may no longer be appropriate.
Plan ahead for lasting success
If your business has more than one shareholder or owner and you have yet to draft a buy-sell agreement, don’t put off this important task. Your success depends on it! If you have questions about how to initiate a buy-sell agreement in your business, we can help you consider tax implications and more. Contact us today.