If you're a business owner, you may already be familiar with buy-sell agreements. These legal documents set rules for the disposition of owners' business interests should they die, become disabled, get divorced or withdraw from the company. Often, life insurance enables other owners to buy the departing owner's portion of the business.
If you already have a buy-sell agreement or are in the process of establishing one, here's how to coordinate it with your estate plan.
Buy-sell agreements provide several important benefits, including keeping ownership and control within a family or other close-knit group, creating a market for otherwise unmarketable interests, and providing liquidity to pay estate taxes and other expenses. In some cases, a buy-sell agreement can even establish the value of an ownership interest for estate tax purposes.
For this reason, it's critical to regularly revisit an agreement's valuation provision — the mechanism for setting the purchase price for an owner's interest — to be sure that it reflects the current value of the business. There are a couple of reasons why now is an appropriate time to review your agreement:
As you review your agreement, pay close attention to the valuation provision. Generally, a valuation provision follows one of three approaches when a triggering event occurs: 1) formulas, such as book value or a multiple of earnings or revenues as of a specified date, 2) negotiated price, or 3) an independent appraisal by one or more business valuation experts.
Independent appraisals almost always produce the most accurate valuations. Formulas tend to become less reliable over time as circumstances change and may lead to over- or underpayments if earnings have fluctuated substantially since the valuation date. A negotiated price can be a good approach in theory, but expecting owners to reach an agreement under stressful, potentially adversarial conditions is asking a lot. One potential solution is to use a negotiated price but provide for an independent appraisal in the event the parties fail to agree on a price within a specified period.
Because the valuation process is, to a certain extent, subjective, there can be some uncertainty over the value of a business for estate tax purposes. If the IRS later determines that your business was undervalued on the estate tax return, your heirs may face unexpected — and unpleasant — tax liabilities. A carefully designed buy-sell agreement can, in some cases, establish the value of the business for estate tax purposes — even if it's below fair market value in the eyes of the IRS — helping to avoid these surprises.
It's important that your agreement isn't structured as a "testamentary device" that's designed to transfer the business to family members or other heirs at a discounted value. Also, your buy-sell agreement should:
Under IRS regulations, a buy-sell agreement is deemed to meet all of these requirements if at least 50% of the business's value is owned by nonfamily members.
The type of buy-sell agreement you use can have significant tax and estate planning implications. Generally, they're structured either as "redemption" agreements, which permit or require the company to purchase a departing owner's interest, or "cross-purchase" agreements, which permit or require the remaining owners to make the purchase.
Cross-purchase agreements can be cumbersome, especially if there are many owners. But these agreements also have significant advantages. For one thing, when the remaining owners purchase a departing owner's interest, they receive a stepped-up basis, reducing their taxable capital gains should they sell those interests in the future. Redemption agreements may trigger a variety of unwelcome tax consequences.
A cross-purchase agreement may also provide an estate planning advantage. Suppose, for example, that you own 35% of a business, your son owns 25% and two non-family members own 20% each. If the company redeems your shares, your family loses control over the business. But a cross-purchase agreement could be designed that gives your son the right to purchase enough of your interest to maintain control.
A buy-sell agreement is just one issue business owners must consider during the estate planning process. To direct the future of your business and personal assets, work with an experienced estate planning advisor.
Get in touch today and find out how we can help you meet your objectives.
