Valuation

Consulting

Business Research

Accountancy

Philanthropy

Buy-Sell Agreements – Revisiting the "Business Will"

Over 90% of the businesses in the United States are closely held (non public). 67% of them will not survive past the death of their founder, and 85% do not survive past the death of the next generation. Yet, only 30% have any business continuity plan, and one third of them are not in writing.

The majority of businesses that do have a continuity plan (buy-sell agreement) have one that is outdated.

A buy-sell agreement is the preferred tool for sole proprietorships with employees, partnerships, LLCs and corporations to continue in business after the death of, or exit of, one or more of the owners. It performs many functions during the lifetime of a business. Properly structured buy-sell agreements between co-owners of closely-held businesses assure a smooth transition of ownership. The buy-sell agreement is the crux of a business’ continuation plan and the owner’s estate because it controls who can or must buy a departing owner’s share, the events that will trigger a buyout, and the price that will be paid upon an owner’s exit (whether voluntary or involuntary). In effect, the buy-sell agreement serves as a business’ will.

At minimum, the buy-sell agreement should address three basic scenarios:

• "Retirement" - What happens if an owner wants to leave the business or sell his/her interest?
• "Disability" - What happens if an owner becomes disabled?
• "Death" - What happens if an owner dies?

The list doesn’t end there. A buy-sell should also cover other voluntary and involuntary conversions, including: divorce, bankruptcy, irreconcilable partner disputes, as well as allowable transfers of ownership. With each of these instances, a method for valuing the business interest must be stipulated, and sufficient funding and/or liquidity must be available to satisfy the interest buyout. A buy-sell also provides minority shareholders a market for their otherwise illiquid stock. Even sole owner businesses need an agreement in place to facilitate the ease of their retirement or address business issues in the event of their death. In the case of a sole business owner, the other party to the buy-sell agreement might be a key employee, another company within the industry, or a major supplier/customer.

Valuation

Some owners elect to value their business at a low level (below fair market value) in their buy-sell agreement, thinking this will reduce their estate tax liability. In doing so, they fail to consider that a buy-sell agreement price is binding for estate tax determination only if it meets five specific conditions and complies with IRC Section 2703, where applicable. If these criteria are not met, the IRS can reject the value for purposes of determining the estate tax due and, in a worse case scenario, the heirs may end up owing the IRS more in estate tax than they received from the sale.

A buy-sell agreement must be updated regularly to ensure its provisions adequately address current business circumstances and the present value of the business interest. The services of an accredited business valuation expert should be engaged to insure an accurate valuation is performed that is compliant with IRC Section 2703 and, therefore, binding upon the IRS for purposes of estate tax calculations. How often should the valuation be revisited? Absent any substantial changes in business structure, ownership, or ownership intent, approximately every two years depending on the nature of the business and change in profits. In the event there is a change in structure, ownership, ownership intent, or a substantial sustainable increase in profits, the valuation should be updated immediately subsequent to that event. Remember, the value of the business interest determines the type and extent of the actions required to minimize tax consequences and insure execution of ownership intent.

The IRS audits nearly 100% of deceased business owner’s estates. Therefore, proper planning must anticipate, and provide for payment of, any federal estate tax due upon the death of an owner. If the business interest is undervalued, the decedent’s estate could be penalized by the IRS for reporting a value less than fair market value; conversely, if the value stipulated in the agreement is in excess of fair market value, the heirs would be subject to unnecessary taxes.

Funding

Buy-sell agreements that do not have a secure source of funding are largely ineffective and of diminimus value. The agreements should provide for adequate capital, or an agreed upon payment structure, to fund a purchase upon a triggering event (i.e., death, divorce, disability, other voluntary or involuntary exits, etc.).

We all understand a business is not static -- sales, product lines, and clientele are ever-changing, all of which directly affect a business’ value. Life circumstances also change (i.e., marriage, divorce, children, etc.). Therefore, the buy-sell agreement and the valuation must be updated on a regular basis to ensure the agreement provides for adequate funding vehicles to support the value of the business interest.

Examine the cost without the implementation of a buy-sell agreement. Assuming the permanent disability of a 50% shareholder, who has developed and nurtured a significant clientele (over the course of 10 years) that generates approximately $8,000,000 in gross sales.

$1,375,000 5 yr. annual salary ($275,000) of permanently disabled shareholder
$875,000 5 yr. annual salary ($175,000) of new sales director
$52,500 headhunter/finders fee for new sales director
+ $2,000,000 drop in revenue from loss of key clients due to shareholder non-participation
$4,302,500 total expenditures/losses without any offsetting compensation

Examine the costs with the implementation of a buy-sell agreement. Assuming the cost of implementing a buy-sell agreement, a professional business valuation, and annual insurance premiums:

$2,500 buy-sell agreement (document & legal fees)
$20,000 professional business valuation
+ $15,800 1st yr. life & disability insurance (combined annual premiums for all owners)
$38,300 total 1st year expenditures with implementation
63,200 cost for 4 additional years of life & disability insurance for all owners
$101,500 total 5 yr. cost

The difference in cost is significant -- $4,201,000.

Taxation

A buy-sell agreement should be structured to minimize taxation. This is especially true for agreements funded by insurance policies. Insurance proceeds can be used to reduce income and estate taxes. However, the transfer in ownership of insurance policies must be planned properly to avoid "transfers-for-value" that subject otherwise tax-free life insurance proceeds to income taxation.

Although a buy-sell agreement might reflect different values for different triggering events, the buy-sell must include a provision that requires the business interest be valued at the greater of either the value determined by the buy-sell agreement or "as finally determined for estate tax purposes." [Remember: When valuing for gift, estate, and inheritance tax purposes the IRS requires the interest reflect fair market value. Fair market value (FMV), as defined by Revenue Ruling 59-60 (IRS valuation guidelines) is defined as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."]

Although the value stated in a buy-sell agreement may be binding upon the owners, it is not necessarily binding on the IRS. Basing the buy-sell agreement on FMV ensures that the deceased owner’s estate will not be forced to sell the shareholder interest back to the company or another owner for a synergistic price, and yet owe a substantially different amount in estate taxes plus penalties in the event of undervaluation. Undervaluation penalties range from 20 to 40 percent depending on the IRS’ assessment.

Consider the Tax Court case of the Estate of H.A. True, Jr. and Jean D. True v. Commissioner, issued July 6, 2001 (T.C. Memo 2001-167). In this case, the IRS determined the estate had almost $76 million in unpaid tax with more than $30 million undervaluation penalties. The Tax Court’s position incorporated several factors. The Court ruled: 1) the buy-sell agreement did not pass the arm’s-length dealings test (as set by the Estate of Lauder v. Commissioner, 2) the buy-sell agreement set terms without negotiation, 3) the decedent failed to rely on the advice of a professional appraiser in selecting the business interest price; 4) the buy-sell agreement excluded significant assets; and 5) the agreement did not provide for periodic reviews or adjustments. This landmark case demonstrates the importance of a properly structured buy-sell agreement, including a valuation performed in compliance with IRS standards.

Death and taxes are inevitable. A buy-sell agreement serves as a business will, and not only guarantees a market for a deceased shareholder’s interest, it protects the living as well. Buy-sell agreements must be periodically reviewed as the corporation grows and as personal situations and tax laws change. After all, it’s not just about the money – it’s also about peace of mind and survivor tranquility. A written, binding, and properly funded buy-sell agreement resolves confusion, and eliminates greed and mental anguish.