Protect your Business with a Buy-Sell Agreement and Help from an Estate Planning Attorney

Posted by Janet Brewer on Mon, Apr 26, 2010 @ 09:18 AM

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A buy-sell agreement helps sustain your business as it changes hands from one generation to the next. One of the keys to an effective buy-sell agreement is a solid provision for valuing interests in the company. Whether shares are valued by an independent appraisal, formula, or agreement of the shareholders, if the amount doesn’t accurately reflect the business’s value, your heirs will pay the price.

If you own a company, you know that business affairs and family affairs are closely intertwined. The company is likely the principal source of your wealth, so your family’s financial future depends on its success. One of the most important factors in a business’s long-term survival is a smooth transition from one generation to the next. A buy-sell agreement can facilitate this transition.

What is it?

A buy-sell agreement is a contract that provides for the disposition of your business interests when you die, become disabled, or leave the company for some other reason. By permitting or requiring the company or other shareholders to acquire your interest, a buy-sell agreement creates a market for your ownership shares, which thereby reduces or eliminates the estate liquidity problems that a block of closely held stock may cause your heirs at death. In addition, a buy-sell agreement may assist in resolving disputes among shareholders. Often, companies use life insurance on each shareholder to fund the agreement so that a deceased shareholder’s family can receive faster payouts.

Factors such as the structure of your business and the degree to which you and others remain involved in it will dictate the buy-sell agreement’s terms. But perhaps the two most important elements of any buy-sell agreement are the triggering events (what will cause your business interests to become available for sale) and how your company will be valued.

Triggering events may include 1) divorce, disability, retirement or death; 2) employment termination of a minority owner; or 3) bankruptcy or loss of a professional license. Ultimately, because buy-sell agreements plan for future uncertainties, yours needs to be flexible in the triggering events it names and how it interprets them.

What’s the business worth?

It’s critical for a buy-sell agreement to establish reliable procedures for determining the value of your business interest. Most agreements set the price in one of these ways:

Independent appraisal. Owners often use fair market value to set the purchase price, typically selecting one or more outside professional valuators to determine this value. If you choose this method, address how you’ll select the valuator or valuators. If you’re using more than one and they disagree, how will you reconcile the difference?

Valuation formula. Some buy-sell agreements include an objective valuation formula, such as a multiple of earnings, sales or book value. Although valuation formulas are straightforward and easy to apply, they fail to reflect the many subjective factors involved in arriving at a value — such as upcoming new products or services, or the power of your good reputation.

Agreement by shareholders. Another effective approach is for you and the other shareholders to meet periodically to review the company’s value and update the buy-sell agreement accordingly. You can use either a formula or outside appraisal to determine the price.

How costly are valuation errors?

Designing a buy-sell agreement that accounts for every factor that affects your company’s value is next to impossible. But if the IRS determines that an estate tax return improperly reflects business value, your heirs may pay the price.

Suppose, for example, that your estate tax return reports your company’s value as $10 million. If the IRS later finds that your business was actually worth $15 million at your death, your estate will face the tax burden on the $5 million difference. At the 2004 top estate tax rate, 48%, your heirs would face $2.4 million in additional tax liability. They might get hit with interest and penalties, too.

The IRS is suspicious of buy-sell agreements it believes are devices to pass your shares to family members for less than adequate and full consideration. Regardless of the valuation method, you can’t use a buy-sell agreement to intentionally lower the value of your business interests to reduce estate taxes. So, as a last step of due diligence, make sure your buy-sell agreement is safe from IRS scrutiny before implementing it — particularly if a related party is a potential buyer.

Buy-sell provides many benefits

A buy-sell agreement helps sustain your business as it changes hands from one generation to the next. It can also provide other benefits, such as improving company morale by reassuring employees of your company’s stability. And, perhaps most important, it protects your heirs from a potentially devastating future estate tax bill. As discussed above, thorough planning and solid valuation provisions are keys to achieving these objectives.