Are you planning to buy a business with co-owners, or do you already own one? If so, it’s important to consider setting up a buy-sell agreement. A buy-sell agreement is essential for business owners because it establishes clear guidelines for the transfer of ownership in specific circumstances. A well-structured agreement can offer several key benefits:
Convert your ownership interest into a more liquid asset
Prevent unwanted changes in ownership
Minimize potential issues with the IRS
The Basics
There are two main types of buy-sell agreements: cross-purchase agreements and redemption agreements (sometimes called liquidation agreements).
A cross-purchase agreement is a contract between you and your co-owners. In the event of a co-owner’s withdrawal, such as due to death or disability, the remaining co-owners must purchase their share.
A redemption agreement is a contract between the business itself and its co-owners. If a co-owner withdraws, the business entity is responsible for buying back their share.
Triggering Events
You and your co-owners will specify the events that trigger the buy-sell agreement. Common triggers include death, disability, or reaching retirement age. You can also include other events, like divorce, depending on your needs.
One of the most common triggering events is the death of a co-owner. Life insurance policies are often used to ensure the necessary funds are available for a buyout:
In a cross-purchase agreement between two co-owners, each co-owner purchases a life insurance policy on the other. Upon one co-owner’s death, the surviving co-owner receives the policy’s death benefit and uses it to buy out the deceased’s share.
If there are more than two co-owners, managing multiple policies can become complex. A trust or partnership can be set up to hold a single policy on each co-owner, simplifying the process and allowing the trust to distribute funds to the remaining co-owners for buyout purposes.
In a redemption agreement, the business itself buys life insurance policies on all co-owners and uses the death benefit to buy out the deceased co-owner’s share.
Here are key reasons why someone might need a buy-sell agreement:
1. Ensures Business Continuity
A buy-sell agreement helps ensure the business can continue to operate smoothly in the event of a major change in ownership, such as the death, disability, or retirement of a co-owner. Without such an agreement, the business may face uncertainty or disputes over who will take over the departing owner’s share.
2. Protects Ownership Interests
It prevents unwanted parties (like heirs or outside buyers) from gaining control of the business. The agreement often stipulates that the remaining owners have the first right to buy the departing owner’s shares, ensuring that the ownership stays within the existing group.
3. Sets a Valuation Method
A buy-sell agreement outlines a clear method for valuing the business in the event of a sale or transfer. This can avoid disagreements about the business’s worth during stressful situations such as an owner’s death or exit.
4. Provides a Smooth Exit Strategy
If one owner wants to leave the business, the agreement specifies how their share will be handled—whether by sale to the remaining owners, back to the company, or to a third party. This helps avoid disputes and provides a fair exit strategy.
5. Protects Family and Heirs
For many business co-owners, their share of the business represents a significant part of their estate. A buy-sell agreement ensures that your ownership interest can be sold by your heirs under terms you approve in advance. Additionally, it helps establish the value of your share for estate tax purposes, reducing the risk of disputes with the IRS.
6. Secures Financing for Buyouts
A buy-sell agreement often includes funding provisions, such as life insurance policies on the owners, to ensure that the business or remaining owners have the resources to buy the departing owner’s shares.
For business co-owners, a well-drafted buy-sell agreement is essential. A buy-sell agreement minimizes uncertainty, prevents conflicts, and protects both the business and its owners during significant changes or transitions. Since buy-sell agreements are complex, they shouldn’t be handled as DIY projects. Contact us to help you set one up.
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