Can Your Business Survive Your Death, Faster than a speeding bullet! More powerful than a locomotive! Able to leap tall buildings with a single bound! Every successful business owner has some Superman-like qualities. They come in handy when starting a business, expanding it, and riding out the rough times. However, even Superman has vulnerabilities. In one instance it might be kryptonite and lead. In another, it might be how to ensure continuation of the business despite your inability to continue with it. That’s where a properly funded business succession plan comes in. And the cornerstone of a business succession plan is the buy-sell agreement. What it is A buy-sell agreement outlines what happens in the event certain events happen, such as death, disability, or retirement. Many such agreements provide that in case of death there is to be a cash buy-out of shares of stock, funded by life insurance. Many agreements further provide that if a shareholder retires or becomes permanently disabled, there is to be a phased buy-out, payable over a term certain with interest. The buy-sell agreement could address other situations as well. For instance, if a shareholder becomes bankrupt or divorced (or if bankruptcy or divorce is anticipated), there could be a provision for the buy-out of that person’s shares of stock. The agreement can also address terminations of employment, whether voluntary or involuntary. In other words, if a shareholder resigns or is fired, would he/she remain a shareholder or would there be a buy-out? Some unfortunate business owners fail to plan for ownership succession. So if something happens, such as the death of a shareholder, the remaining stockholders may find they are now partners with the spouse or children of the deceased. They then have to negotiate with the grieving family on how to compensate them for the return of their shares of stock. Types of Agreements The buy-sell agreement could be structured as either a cross-purchase agreement between and among the shareholders, or as a redemption agreement in which the corporation redeems the shares of stock. Which type is best depends on many factors, as one needs to balance the tax effects of such a transaction against the practicalities of structuring the buy-out. The sale and purchase could also be structured as either mandatory or optional with the corporation or its shareholders. What works for one business may not work for another, and a buy-sell agreement should be tailored to your unique needs and wishes. Optional Provisions A buy-sell agreement can also include optional provisions. For example, perhaps each shareholder could agree to a covenant not to compete against the business for a term of years and within a certain geographic area. Or perhaps there should be a first right of refusal provision that provides a mechanism for a shareholder to offer his/her shares to someone outside the company (or to another shareholder), but providing the remaining shareholders or the corporation with the right to exercise an option to buy back the shares instead. How to Value the Business One key decision to be made is how to determine the buy-out price. Some agreements provide that the shareholders stipulate as to a certain value and update it from time to time. A drawback to this approach is that the shares of stock might go up or down quite a bit in the future, but yet the parties to the agreement are stuck with the most recently stipulated value. Another approach is to provide for an independent appraisal of the business. Those agreements often include a process for the selection of who will do the appraisal. Of course, this can introduce an element of perceived subjectivity, as either the buyer or seller of the shares of stock is likely to be in disagreement with the findings of the appraiser. For these reasons, many business owners opt for a valuation formula in their agreements, usually involving some multiple of earnings, revenues or book value. In the construction contracting industry, most internal deals in the last five years are based upon some approximation of book value plus/minus a premium/discount. Funding the Buy-Sell It is essential to fund a buy-sell agreement with the proper kind and amount of insurance. It happens all too often that when a major shareholder dies, there isn’t enough insurance to achieve the buy-out. There once was a family-owned company that insured for an amount equal to its current market value of the stock. These business owners made the mistake of failing to take into account an expected expansion, and they purchased a ten year level term life insurance product. Ten years later, they found that the company had quadrupled in value, that the insurance was insufficient to achieve a buy-out, that continuation of that policy was cost-prohibitive, and that the major shareholder was uninsurable -- he had just recovered from a heart attack. Looking back at it, these business owners found themselves regretting they had opted for a term policy instead of a more permanent type of insurance product with a greater death benefit. IRS Attacks on Buy-Sell Agreements In a family business context, the IRS tends to be suspicious of buy-sell agreements that understate the value of the company. Perhaps you have a business in which your shares of stock are valued at $3 million according to the buy-sell agreement, and perhaps the company or the other shareholders acquire a life insurance policy with a face value of $3 million to finance the buy-out. It is possible that the IRS, in an estate tax audit, could determine that the business is actually worth $7 million. If this is done in a year where the marginal estate tax bracket is 50%, the result would be an additional $2 million (!) of estate tax, plus interest and penalties. This means that the IRS would get about $3.5 million for stock that was redeemed from the estate for only $3 million! The Internal Revenue Code says that if you have a buy-sell agreement, you cannot transfer a business to your family for less than full and adequate consideration in money or money’s worth. This Code provision is intended to prevent a business owner from artificially reducing the value of his/her shares of stock by utilizing a buy-sell agreement with an arbitrary sales price. In a Nutshell Ownership of your business is probably the single most valuable asset you have. If you lose a key employee or if something happens to you, it makes good sense to have a plan in place that permits the continuation of the business and the transfer of ownership. How to structure such a plan involves taking into consideration the needs of the business, the needs of your family, the interpersonal dynamics among the shareholders, and the presence of the ever-opportunistic IRS. We at Large & Gilbert, P.C. can help you formulate an appropriate structure that addresses the continuation of the business and the plan for ownership succession. That way, when your head hits that pillow at night, you can rest assured you’ve done the best job possible to provide for your family while doing the right thing for your business. Specifically, we can help you put in place a business succession plan that is able to withstand IRS scrutiny. We can also help you make sure that your buy-sell agreement is funded properly with the right kind and amount of insurance. We want you, our client, to feel secure and confident knowing you have in place a sound plan for the survival of your single most important asset: your business. |
