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A Better Partnership

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Jun 2005
01
June 01, 2005

Buy and Sell Agreements: An Important Part of Your Family's Estate and Business Succession Plan

Many think of Buy and Sell Agreements as being solely the concern of shareholders of closely held businesses. Not as readily evident is the important role they play in the estate plans and succession plans of family business owners. Buy and Sell Agreements can be an important or even central part of the estate plan for members of the family business.

What is the Buy and Sell Agreement?

A Buy and Sell Agreement is an agreement between a company and its owners setting forth the basis on which interests in the company may be transferred or sold. In the case of limited liability companies, these provisions most commonly are included within the company's Operating Agreement. For corporations there may be one Buy and Sell Agreement between the company and all of the owners, or there may be separate Buy and Sell Agreements between the company and each owner.

The Buy and Sell Agreement typically restricts transfers of ownership interests in the company and provides a mechanism for the purchase and sale of ownership interests upon specific events, such as death, transfers to creditors, transfers to former spouses in conjunction with divorce, or if a owner wishes to sell his or her interest. The Buy and Sell Agreement will provide a procedure for the purchase and sale of the interest, including a mechanism for establishing the price and terms upon which the ownership interests will be sold. In Buy and Sell Agreements involving S Corporations, the Agreement typically includes provisions designed to preserve the S election. Buy and Sell Agreements for companies taxed as S Corporations or partnerships also will often include provisions intended to ensure distributions of at least a portion of the profits to ensure the owners are able to pay the taxes due upon their allocable share of the company’s income.

Why is the Buy and Sell Agreement important to the Estate Plan?

The Buy and Sell Agreement often supports several parts of the business owner's estate plan. These include:

  • The Agreement can ensure the existence of a market for the stock following a death. This can be important to ensure that funds can be made available to pay taxes levied upon the estate of the deceased owner.

  • During the owners' lifetime, the Buy and Sell Agreement can ensure that owners do not improperly transfer shares to individuals deemed inappropriate or unworthy as owners of the business. A common example are ex-spouses following divorce. Another example is a change in trustee of a trust owning shares to an inappropriate person, such as someone who is not part of the family owning the business.

  • The Buy and Sell Agreement also can set the price at which the ownership can be transferred. If properly established, this price will be respected for estate tax and gift tax purposes.

  • The Buy and Sell Agreement can provide a mechanism to deal with otherwise difficult questions of treating members of a family fairly and equitably. For example, suppose a business represents 60% of mom's and dad's wealth, and they have three children, only one of whom is active in the business. Further suppose that mom and dad want only the child who is active in the business to own it after they both die, but also want to ensure that all three children share equally in their wealth. A Buy and Sell Agreement that gives the children the right to force the purchase and/or sale of the stock from the children who are inactive establishes a means to achieve each of mom's and dad's objectives: equal distribution of the parents' wealth among their children, and passing ownership of the business to the child active in the business.

What are some common mistakes involving Buy and Sell Agreements?

There are many things that can go wrong with Buy and Sell Agreements, which illustrate the importance of careful planning and monitoring of the Buy and Sell Agreement. Some common pitfalls include:

  • Failing to update the purchase price. Many Buy and Sell Agreements require the owners to annually set a new price for the ownership interests. Failing to re-establish the price on a regular basis can result in a price that the IRS may not accept or that seriously shortchanges a buying or selling shareholder.

  • Using an inappropriate measure of the purchase price. Some Buy and Sell Agreements still use book value as a measure for the purchase price. Book value in nearly all instances fails to adequately measure the true value of the ownership interest. In addition, the IRS may not respect the price for purposes of estate or gift taxes. In other cases, a formula is used, but is not regularly monitored, which can result in buyers or sellers being treated unfairly.

  • Failing to consider the impact of the Buy and Sell Agreement on the balance of control or governance of the business. As ownership interests change following gifts and repurchases following death or retirement or other events, the purchase and sale of ownership interests under the terms of a Buy and Sell Agreement can result in changes in the control of the business that may not have been contemplated or planned when the Agreement was prepared.

  • Failing to provide adequate funding for future purchase obligations. Where known or likely repurchase events will occur, the ability of the prospective purchasers to pay for the interests should be considered. It may be important that adequate life insurance is obtained, and where insurance is important, it will be important that the amount keeps pace with changes in the value of the interests and purchase obligations, that the policies performance is monitored on a regular basis, and that the purchaser and beneficiaries are aligned so that death benefits are paid to the proper party when a death occurs.

Conclusion

A Buy and Sell Agreement is an important part of the estate plan because it helps ensure a market and fair and equitable treatment of the members of a business owning family. Frequent monitoring and review of the Agreement is an important and essential part of estate planning and planning for the succession of the business.

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