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Business Succession Planning – Buy-Sell Agreement Basics

by Alex J. Wolf and Clark R. Youngman, Attorneys, Koley Jessen P.C., L.L.O.

This is the final article in a three part series intended to demystify business succession planning and its implementation. The first article provided a high-level overview of the succession planning process. The second article outlined some foundational aspects of succession planning, including information about the “basic” estate plan documents and other considerations. This third article will provide an overview of buy-sell arrangements, including the types of buy-sell agreements, common provisions included in buy-sell agreements and the typical “trigger events” that they cover. Our hope is that through this series of articles business owners will have enough information to see how proper succession planning can positively impact the future of their business and the well-being of their family and employees.

Generally, a buy-sell agreement is a contractual arrangement signed by owners of a business that restricts how and when the owners can transfer their equity interests, and sets forth options or obligations for the entity or other owners to buy the equity interests at a certain price upon the occurrence of a specified event or “trigger.” Although a buy-sell agreement is often a stand-alone document, this is not a requirement, and buy-sell provisions can often be found in a variety of places, including formation documents (e.g., articles of incorporation/organization), governing documents (e.g., bylaws, operating agreement or partnership agreement), and elsewhere (e.g., employment contracts). In crafting the buy-sell agreement there are several objectives that may be addressed. These objectives often include: (i) controlling who may become an owner; (ii) providing for a smooth and timely transition of control so as to not disrupt business operations, (iii) creating a market/providing liquidity for the owners of their equity interests, (iv) providing a means to remove an owner, (v) creating a mechanism to value equity interests, (vi) providing the terms and manner of the purchase, and (vii) providing a means to resolve disputes among the owners.

Types of Buy-Sell Agreements
There are three main types of buy-sell agreements: (i) cross-purchase agreements, (ii) redemptive agreements, and (iii) “hybrid” agreements that contain both cross-purchase and redemptive agreement features.

Cross-Purchase Agreements. The first kind of buy-sell agreement is a cross-purchase agreement, which is where the equity interest is purchased from one owner by the owner(s). The primary advantages of a cross-purchase agreement include: (i) the remaining owners receive an increased tax basis on the purchased equity interests, and (ii) life insurance proceeds received by the purchaser are not subject to claims by the entity’s creditors, nor are they subject to the alternative minimum tax. Some potential disadvantages include (i) administrative complexity when there are multiple owners (e.g., if a purchase is to be funded with life insurance, it can result in convoluted web of cross-ownership of the policies), (ii) younger owners may be unable to afford to purchase the equity interests of more senior owners or the insurance premiums necessary to maintain adequate insurance, and (ii) there may be negative tax implications (i.e., “transfer-for-value” rule) related to the insurance following the death of an owner.

Redemptive Agreements. In a redemptive buy-sell agreement, the departing owner’s equity interests are purchased by the entity. The main advantage of a redemptive style agreement is its simplicity. The disadvantages are that the remaining owners of a C corporation do not receive a step-up in basis and insurance proceeds received by the entity are subject to the entity’s creditors and the alternative minimum tax.

Hybrid Agreements. A hybrid agreement combines both cross-purchase and redemptive arrangements in an effort to capture as many of the advantages and minimize as many of the disadvantages discussed above as possible. Hybrid agreements can be lengthy and must be very well thought through to ensure the desired objectives are accomplished.

Common Buy-Sell Provisions
Buy-sell agreements commonly include provisions dealing with each of the following:

  • Parties involved;
  • Statement of purpose;
  • Description of interests subject to the agreement;
  • Restriction on transfer;
  • Commitments of the parties to buy/sell upon occurrence of certain “trigger” events;
  • Purchase price/valuation methodology;
  • Funding/payment terms; and
  • Modification/termination provisions.

One of the most important items included in a buy-sell agreement is the “restriction on transfer” which provides that no party may transfer their equity interests other than as provided in the agreement. It can be structured either as an absolute restriction (i.e., meaning that the transfer is simply not allowed) or as a “right of first refusal” (i.e., where the transfer is allowed only after an option to purchase has been granted to the other owners and/or the entity). The restriction on transferability is commonly subject to exceptions for certain “permitted transferees,” which allows specific persons or classes of persons to receive equity.

The agreement also outlines obligations or options of the parties to buy/sell the equity upon the occurrence of certain “triggers,” the most common of which include the following:

  • Attempted transfer to a third party;
  • Death of an owner;
  • Disability of an owner;
  • Termination of employment of an owner;
  • Retirement of an owner;
  • Involuntary transfers (e.g., bankruptcy, divorce, etc.);
  • Expulsion of an owner; and
  • Put option (i.e., option of an owner to demand that they be bought out) and call option (i.e., option of owners/company to buy an owner out).

Determining which triggers to include is fact-specific and often is driven by the nature of the business (e.g., operating entity vs. a property holding company), the relationship of the parties (e.g., family vs. unrelated) and the objectives of the business. Another important aspect of the trigger events is working through which parties have the options/obligations to buy upon the occurrence of the relevant trigger. For example, in a business involving multiple families as owners, sometimes the option is granted to blood relatives before allowing other unrelated owners to buy upon a specific trigger.

The parties agree in advance on the methodology for determining purchase price for any given transaction under the agreement. For example, common methods utilized include (i) establishing a “pegged-price” (i.e., fixed value that is agreed to in advance) in the agreement and on an annual basis, (ii) using a formula (e.g., multiple of earnings, adjusted book value, etc.), (iii) getting an independent appraisal of the business or underlying assets, or (iv) the “shotgun” approach (discussed below). It is worth noting that the purchase price determined in the agreement may establish the value of the interests for estate tax purposes. However, the agreement is not binding on the IRS, and accordingly the parties are typically encouraged to have the purchase price utilized at death closely reflect fair market value in order to minimize IRS scrutiny.

The agreement also outlines the terms and manner in which the purchase price will be paid. The purchase price can be paid entirely in cash at closing, over time via promissory note, or a combination of the two (e.g., down payment of a certain percentage with a promissory note for the amount outstanding). Also considered in the context of payment terms is whether the application of insurance proceeds is mandatory and, if a promissory note is involved, whether the promissory note will be secured or unsecured.

The purchase price and payment terms utilized can vary depending on the event that triggered the purchase. For example, if the trigger event involved the forcing out of an owner (e.g., involuntary termination of employment or exercise of the call option), it would seem appropriate for the subject of the call option to get full fair market value (or perhaps even a premium) for his or her equity interests, and would be paid out in full at closing. These provisions would help protect an owner who is forced out, and encourage the other owners/company not to act capriciously. On the other hand, if the trigger was due to an owner exercising his/her put option, it seems more appropriate for the departing owner to receive a discounted purchase price and receive a smaller down payment at closing and a promissory note with a longer repayment term. These provisions would help account for the potentially difficult financial position the departing owner is leaving the company or other owners.

Parties to a buy-sell will sometimes include a dispute resolution provision (i.e. “shotgun” provision) to address instances where there is deadlock between two 50/50 owners or groups of owners. This provision essentially allows one party to set the purchase price for the equity interests, and then the other owner decides whether he/she will be the purchaser or the seller based on that purchase price. The theory behind this approach is that the exercising party will try to be as fair as possible in setting the purchase price because he/she does not know whether he/she will end up being the purchaser or the seller. However, if one of the parties clearly lacks the resources to be a purchaser (i.e., such that the other party can set a less than fair price knowing the other party cannot afford to purchase), shotgun provisions may not have the desired result.

Finally, the parties will commonly include provisions on how the agreement can be modified or revoked. Typically, if all of the parties agree, they can alter the agreement or deviate from its terms in connection with any trigger event, purchase price or payment terms established in the agreement.

As is evidenced by this and the preceding articles in this series, businesses succession planning truly is a process that requires commitment and thoughtfulness to be properly implemented; it is not a one-size-fits-all proposition as each succession plan may differ in significant ways. It may seem like a daunting task, but if given appropriate attention and thought, a business succession plan can successfully be implemented and help ensure the business carries on for the successor owners and employees of the business.

Required IRS Circular 230 Notice: Any advice expressed as to tax matters was neither written no intended to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under U.S. tax law or otherwise complying with IRS Circular 230.