Buy-sell agreements, also known as buy-out agreements, are enforceable contracts between or among the existing owners and the company. Buy-sell agreements spell out when and on what terms an owner may sell his own interests in the company or purchase the interests of another owner upon the occurrence of a future event, such as the death, disability bankruptcy, divorce, termination, or retirement of an owner. Buy-sell agreements also define if and when an owner can sell his or her interests to a third party.
In a “redemption agreement” the company has the option obligation to purchase the departing owner’s interest, depending on the terms of the agreement. In a “cross-purchase” agreement the remaining owners have the same right or obligation. Many Buy-sell agreements contain both provisions with the company usually having the first right of refusal.
Purposes of Buy-Sell Agreements
- Ensuring continuation of the company when ownership interests change hands.
- Preventing third-parties from obtaining control of the company without the permission of the remaining owners.
- Establishing the value of the departing owner’s interest and providing the means and terms by which the company or remaining owners will pay.
- Minimizing the tax impacts of changes in ownership, especially payments received by the departing owner.
- Preserving S corporation status, preserving professional business status, and preventing inadvertent termination of a partnership tax status, if applicable.
- Anticipating and resolving potential future disputes between or among the owners, the company and the departing owner’s family.
- Buy-sell agreements also often serve as an estate planning tool for the owners.
Funding Buy-Sell Agreements
One of the most difficult problems owners of closely-held companies face is how to turn their ownership interests into cash when they leave the company. There are four basic options for funding buy-sell agreements apart from the selling the company in toto. Unfortunately, none is without risk or complication.
First, the company could borrow the funds necessary to buy the interests of the deceased or withdrawing owner. The lender will require substantial collateral and, most likely, personal guarantees by the remaining owners. It’s also possible that the company or the owners will not qualify for a loan.
Second, the company can create an employee stock ownership plan (ESOP). An ESOP is a trust into which the company makes tax-deductible contributions. Funds in the trust are used to purchase the departing owner’s interests in the company. ESOPs must generally be established well in advance of an owner’s retirement or death. They may only be used by C and S corporations and only C corporations can take full advantage of the tax benefits. Also, the company must either generate enough profits to conduct its normal business while making the necessary reinvestments or qualify for a loan to fund the ESOP. ESOP benefits must be provided to all employees who have worked at least 1000 hours but vesting requirements of up to six years may be imposed.
Third, the company may also fund or partially fund a buy-sell payout with life or, disability insurance. When using insurance to fund a buy-out, the transfer-for-value rule must be addressed. This law treats insurance proceeds as ordinary income to the recipient (or his or her estate) if the policy is transferred to another for valuable consideration. A life insurance trust can be created to avoid the transfer-for-value rule where the company is responsible for purchasing the outgoing shareholder’s interests. Similarly, in cross –purchase agreements, where the remaining owners are responsible for buying-out the departing shareholder, a separate partnership can be created to own the partner’s policies to avoid the transfer-for-value rule, as long as the partnership has a purpose other than tax avoidance. Significantly, the transfer-for-value rule does not apply to LLCs.
A disability-funded plan generally requires that the disability continue for one or two years before any payments are disbursed.
Finally, the company can establish a sinking fund or other reserve account to fund the buy-out of an owner. This has the obvious disadvantage of tying up a significant amount of funds that could otherwise be used to operate or expand the company. Such funds are also potentially accessible by creditors of the company and may be subject to a 15% accumulated earnings tax, if the IRS deems the company’s retained earnings unreasonable and excessive. For these reasons, sinking funds or reserve accounts should only be considered a last resort.
Hire Experienced Counsel to Draft or Review Your Buy-Sell Agreement
Due to its fundamental importance to the company and to the owners, it is imperative you hire experienced legal counsel draft your buy-sell agreement. Each owner should have separate counsel to review all terms before it is signed.