Address ownership transfer issues with a buy-sell agreement

There are a number of reasons why owners of closely held businesses put off discussing how ownership interests will be transferred when an owner exits the firm. For one, owners may be concerned about conflicts that could arise if an owner wants to transfer interests to family members or sell them to outsiders.

For another, issues such as how fellow owners (or the business itself) will be able to pay for an exiting owner’s interests or the effect of the agreement on estate taxes can seem overwhelmingly complex. Fortunately, a buy-sell agreement can address these issues and more, provided it’s drafted carefully.

Resolving transfer issues

A buy-sell agreement sets up the guidelines for the transfer of business ownership interests under certain predefined events, such as death, legal incapacity, retirement, loss of professional license, bankruptcy and divorce. Agreements usually address such issues as the method that will be used to value the interests and to whom ownership can be sold or transferred.

Buy-sell agreements are particularly beneficial for closely held businesses. Why? Because they create a ready market for shares that would otherwise be difficult or impossible to sell.

For instance, when you die, your heirs might otherwise be hard pressed to find a buyer for your shares. With a buy-sell agreement in place, rather than being saddled with having to find someone on their own, your heirs would simply go to the other owners or the company itself to redeem your ownership interest.

At the same time, an agreement can protect the remaining owners from having a new, unwanted owner — such as an exiting owner’s heirs or an outside buyer — thrust upon them.

Funding it

Insurance is a common funding vehicle for buy-sell agreements, and there are three types of agreements that use it. One is the cross-purchase agreement, under which each owner buys life or disability insurance (or both) on each of the other owners. At one owner’s death or incapacity, the other owners collect on their policies and use the proceeds to buy the deceased or incapacitated owner’s shares.

Another is the redemption agreement. In this situation, it’s the business — not each individual owner — that buys the insurance. So the company would acquire the shares of the deceased or incapacitated partner. Redemption agreements can be particularly beneficial when there are a lot of owners, because fewer insurance policies are needed than under a cross-purchase agreement.

Last is the hybrid agreement, which is a combination of the cross-purchase and redemption agreements. Generally, the agreement requires that the shares first be offered to the business for redemption. If the company is unable to pay for the shares, the other owners are then responsible for buying the exiting owner’s interest.

Estate tax considerations

Many owners also use buy-sell agreements as a tool to determine an ownership interest’s value for estate tax purposes. But the IRS may challenge a value derived from a buy-sell agreement.

To design a buy-sell agreement that will pass muster with the IRS for estate tax purposes, look at Section 2703(b) of the Internal Revenue Code. It states that value as defined for estate tax purposes is valid so long as the agreement:

• Is a bona fide business arrangement,

• Isn’t a device to transfer such property to members of the deceased’s family for less than full and adequate consideration in money or money’s worth, and

• Has terms that are comparable to similar arrangements entered into by persons in an arm’s length transaction.

If the agreement fails these tests, the value claimed for estate tax purposes may be challenged.

An ideal tool

Under the right circumstances and with the proper guidance, a buy-sell agreement is an ideal tool for transferring ownership. But be sure to proceed carefully, because an improperly constructed agreement can cause more problems than not having an agreement in place. •