If you own a closely held business with at least one other partner, certain steps can be taken to guard against business disruption if you or the partner unexpectedly dies or becomes disabled. One of the most important steps is to create a buy-sell agreement.
A buy-sell agreement is a critical component of business continuation and succession planning for partnerships. This agreement sets the terms, conditions and price at which an owner’s business interest can be sold to another owner (or owners) before an unexpected tragedy happens. It also places a value on the business for federal estate tax purposes.
Avoiding turmoil and conflicts
A business owner’s unexpected death or disability can lead to turmoil and potential conflicts between the surviving partners and the deceased or disabled owner’s family members. Such disorder has the potential of disrupting normal business operations, and can result in instability for employees, customers, creditors, investors and other stakeholders.
One of the worst potential scenarios is when a deceased or disabled owner’s spouse becomes an unwilling partner in the business. Without a properly structured buy-sell agreement in place, the spouse could be thrown into this situation — even if he or she knows little about the business and doesn’t want to actively participate in running the company.
A buy-sell agreement ensures that your heirs are fairly compensated for your business ownership interest at a predetermined price. Your partners, meanwhile, don’t have to worry about your spouse (or other family members) becoming unwilling (and unknowledgeable) co-owners. And your employees will benefit from less workplace stress and disruption than would otherwise be caused if a partner dies or becomes disabled.
2 types of buy-sell agreements
In most situations, a buy-sell agreement is funded with a cash-value life insurance policy or a disability buyout insurance policy. There are two main types of life insurance-funded buy-sell agreements:
- Cross-purchase agreement. Partners buy insurance policies on each other, using the proceeds to purchase a deceased or disabled partner’s ownership shares. They receive a step-up in cost basis that may reduce taxes if the business is later sold. This option is usually preferable if there are three or fewer business partners.
- Entity purchase agreement. The business entity buys insurance policies on each partner and uses the proceeds to buy a deceased or disabled owner’s shares, which are divided among surviving partners. Partners receive no step-up in cost basis with this type of agreement. This option is usually preferable if there are four or more partners, because it eliminates the need for each partner to have to buy so many insurance policies.
It’s usually wise to hire a professional business appraiser to perform a business valuation when drafting a buy-sell agreement. The valuation should then be updated periodically as circumstances that could potentially affect the value of the company change. In fact, the buy-sell agreement itself should be reviewed by all of the partners from time to time to make sure it still reflects each partner’s intentions.
A final thought
Remember, having a poorly drafted buy-sell agreement can be worse than not having one at all. Consult your attorney and your CPA for advice on the type of agreement that will best serve your business.