Buy-Sell Agreements

Within a closely held business, owners are often concerned about what might occur if one of the owners dies or becomes disabled. Will the deceased owner’s family retain the economic value of the business’ interest? Can the surviving owners avoid interference from the deceased owner’s family? Will the survivors have the economic resources to redeem the deceased owners’ interest? Given these concerns, business owners are best served by entering into a buy-sell agreement in the early stages of their business.  A buy-sell agreement is a legally binding contract in which the owners of a business set forth the terms and conditions of a future sale or buy back of a departing owner's share of the business. Buy-Sells control when owners can sell their interests, who can buy an owner's interest, and at what price.  Some states help solve some of these concerns by issuing laws as to who can own certain professional practices.   For example in Oregon, only a person licensed as a dentist by the State Board of Dentistry may own, operate, conduct or maintain a dental practice, office or clinic in the state (Oregon S.B. 117). These laws may present other issues however such as a forced fire-sell. 

A typical buy-sell allows a business entity or professional practice the opportunity to purchase a departing owner's business interest at a predetermined price. This allows the business and the remaining owners to protect themselves from future adverse consequences, such as disruption of operations, entity dissolution, or business liquidation that might result if certain events, such as an owner's sudden incapacity or death should occur. This can also minimize the possibility that the business will fall into the hands of outsiders.

The ability to fix the purchase price as the taxable value of a business interest makes this tool especially useful in estate planning. Agreeing to a purchase price while all parties are alive minimizes the possibility of unfair treatment to a deceased owner's heirs. And, the IRS' acceptance of this price as the taxable value can help minimize estate taxes on the deceased owner's business interest.

Additionally, because funding for buy-sells is typically arranged when the buy-sell is executed, the possibility that funds will not be available when needed is minimized, and a deceased owner's estate can be provided with needed liquidity for expenses and taxes.

How does a buy-sell agreement work?

A buy-sell can be a separate agreement or can be created by including buy-sell provisions in a business' operating agreement.

A buy-sell must clearly identify the potential buyers, any restrictions and limitations, and the conditions under which a sale will occur. Sale triggering events typically include:

• Death
• Long-term disability
• Retirement
• Divorce
• Personal insolvency or bankruptcy
• Criminal conviction
• Loss of professional license
• Resignation or termination of employment

A buy-sell should set forth the purchase price or a formula for determining the purchase price. Without establishing this price in advance, lengthy disputes and lawsuits can arise at the time the ownership interest must be bought back.

Financing the buyout

For a buy-sell to be successful, funds must be available to carry out the terms of the buy-sell.

Without a funding plan in place, the buyer(s) may be forced to sell assets, take out loans, or even file for bankruptcy. There are several ways to fund a buy-sell, including:

• Cash
• Borrowings
• Installment sale
• Self-canceling installment note
• Private annuity
• Stock redemption
• Sale-leaseback
• Appreciated property bailout
• Deferred compensation
• Life insurance
• Disability insurance

Factors that generally influence the choice of funding method include:

• Business structure, size, and tax bracket
• Number of owners, their ages, tax brackets, and ownership percentages
• Levels of cash or credit available to the business or the owners
• Type of buy-sell agreement
• Depending upon the specific details, there might be just one funding method that is appropriate, or there may be several funding methods that could be used.

Structuring buy-sells

Buy-sells can be structured to meet the needs of both the business and the owners, taking into consideration tax consequences and individual goals. There are four basic structures for buy-sells, and some combinations are possible. A very brief description of the four basic structures follows:

• An entity purchase buy-sell obligates the business to buy the interests of each departing or deceased owner.
• With a cross purchase buy-sell, each owner agrees to buy a share of a departing or deceased owner's interest. The business is not a party to this type of buy-sell.
• A unilateral or one-way buy-sell is used when only one owner is selling an interest, and is typically used in single doctor/owner situations where the owner is arranging to sell the entire business to a family member or key employee.
• A wait-and-see buy-sell is used when the parties are unsure whether the practice or the owners will buy the business interest. Typically, the business is given the first option, and if it does not exercise the option, the remaining owners are given the opportunity. If the remaining owners do not exercise their option, the business is obligated to buy the interest, just as with an entity purchase buy-sell.

Example

Brack and Band became best friends in orthodontic residency.  Brack was a great technical clinician and loved complex orthodontic cases.  Band had a great business sense and dreamed of growing a successful orthodontic practice. 

As soon as they finished their training, Brack and Band borrowed some money and bought an orthodontic practice from a retiring orthodontist. Over the years, they built a very successful practice—Brack become known in the community as the doctor who could straiten any crooked tooth and Band concentrated on simpler cases as well as managing the business side of the practice. 

While their business thrived, their personal lives flourished as well--each marrying and having several children.  But then, one day, Brack unexpectedly had a heart attack and died.  Brack’s family was overwhelmed with shock and grief.  After several weeks, Brack's widow, Dentina, came by Band’s office. Dentina was very nervous--she needed to broach the subject of her husband's interest in the practice and building, but knew Band was having a difficult time managing the business on his own. Dentina was having her own financial difficulties, however, having a large mortgage to pay and two children in college. She couldn't put off this meeting, even if it resulted in tension and bad feelings.

To her delightful surprise, Dentina soon discovered how much foresight her husband and his business partner possessed.  They had executed a buy-sell agreement many years ago, just in case such an unfortunate event should occur, and financed the agreement with life insurance policies on each other's lives.  Band was in the process of claiming the proceeds and would pay Dentina the agreed-upon purchase price. Dentina received her rightful share of the business, in cash, with which she was able to meet her family's needs. Band was able to continue the business with little interference. And though it wasn't quite the same, he hired an associate orthodontist to help manage the patient load, and the practice continued to operate successfully.

Advantages

• Assures continuation of a business
• Assures a smooth transition of a business
• May prevent loss of entity status due to restrictions on transfers of interests (S corporations and limited liability companies)
• Provides assurance to creditors, customers/patients, and employees
• Guarantees a buyer for a departing owner’s interest
• Can prevent outsiders from gaining control of the business
• Establishes a taxable value in advance, minimizing estate taxes and potential valuation conflicts with IRS at time of owner's death
• Protects heirs from unfair treatment
• Ensures estate liquidity

Disadvantages

• Depending on the type of buy-sell, there could be adverse income tax consequences to the business and/or the owners
• Meticulous drafting is required-- improperly drafted buy-sells can result in unintended consequences and tax code violations
• Valuations may need to be updated from time to time
• If funded with insurance, care must be taken to provide continuing coverage

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. It is for general information only and is not intended to serve as specific financial, accounting or tax advice.