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Published on: 03/27/2024 • 9 min read

Key Considerations When Creating a Buy-Sell Agreement

A well-constructed buy-sell agreement is akin to a strong foundation for your business partnership or closely-held corporation. It lays out the groundwork for handling potentially difficult situations such as the departure, disability, or death of a business owner. Without a solid agreement in place, your business may be vulnerable to unforeseen legal battles, disruptions, or even dissolution in the face of these circumstances. 

While the thought of creating a buy-sell agreement might seem daunting, focusing on a few key considerations can make the process more manageable and help you to secure your business’s future. Here are some critical points to keep in mind throughout the process:

  • Valuation of the business: Establishing a fair and agreeable method for valuing the business is crucial.
  • Funding the buy-out: Options include life insurance, personal funds, or loans.
  • Trigger events: What circumstances will activate the buy-sell agreement?
  • Transfer restrictions: Guidelines on who can buy into the business and under what conditions.

In this article, the financial advisors from Avidian Wealth Solutions will expand on each of these key considerations, exploring how each one could impact your buy-sell agreement and the future health of your business. 

What is a buy-sell agreement?

A buy-sell agreement, also known as a buyout agreement or a business continuation agreement, is a legal contract that outlines the terms and conditions governing the sale of a business or ownership interests in a business. The owners of a business typically use buy-sell agreements as an essential piece of their overall exit planning strategies to establish a clear and structured process for handling ownership changes due to events like death, disability, retirement, or voluntary sales.  

Buy-sell agreements are essential for protecting the interests of all parties involved and ensuring a smooth ownership transition. There are several different types of buy-sell agreements, all of which can be customized to fit the specific needs and preferences of the business owners. Some common types of buy and sell agreement examples include: 

Cross-Purchase Agreements: 

In a cross-purchase agreement, each owner or partner in the business agrees to purchase the ownership interest of another co-owner should certain triggering events occur, such as death or disability. This type of agreement is often used in businesses with only a few owners. 

Stock-Redemption Agreements: 

In a stock redemption agreement, the business entity agrees to buy the ownership interest of a departing owner. The business entity purchases the shares or ownership units, effectively retiring them, and the remaining owners maintain their proportionate shares. 

Hybrid Agreements: 

A hybrid buy-sell agreement combines elements of both cross-purchase and stock redemption agreements. It allows flexibility in choosing who will buy the departing owner’s interests and under what circumstances. 

Wait-and-See Agreements: 

This type of agreement postpones the decision on who will buy the departing owner’s interest until the triggering event occurs. The remaining owners have the option to choose whether to purchase the interest themselves or allow the business entity to buy it. 

Right of First Refusal Agreements: 

In a right of first refusal agreement, a departing owner must offer their ownership interest to the existing co-owners or the business entity before seeking an outside buyer. This allows the current owners to maintain control of who becomes a co-owner. 

One-Way or Unilateral Agreements:  

In this type of agreement, only one party (usually the majority owner) can buy the other party’s shares. This can be used when the ownership structure has a clear power imbalance. 

Four factors to consider when creating a buy-sell agreement

The specifics of your buy-sell agreement will vary widely, based on factors including the valuation method for the business, the funding mechanism for the buyout, and the triggering events. As mentioned, these agreements help provide a structured and fair process for handling ownership changes and can prevent disputes and disruptions in the business.

Because of this, it’s essential to consult with legal and financial professionals when drafting a buy-sell agreement as part of your business succession planning strategy to make sure that it meets the business’s and its owners’ unique needs and circumstances. Here are four critical factors to consider when creating a buy-sell agreement:

1. Valuation of the business

Determining the value of a business is often complex and subjective, making it one of the most crucial elements of a buy-sell agreement. Various approaches can be used for valuation, including market, income, and asset-based methods. Each has its advantages and is more suitable for different types of businesses.

A well-defined valuation process within the agreement offers clarity and fairness for all parties involved. It is advisable to also specify how often the business should be revalued, as its worth can change over time due to market conditions, financial performance, and other factors. Incorporating a periodic valuation review can help keep the agreement up-to-date and reflective of the current business scenario.

2. Funding the buy-out

Funding a buy-out is another critical component of a comprehensive buy-sell agreement for a small business. It’s important to determine in advance how the purchase of a departing owner’s interests will be financed. 

Life insurance policies are a common method for funding buy-sell agreements, especially in the event of an owner’s death, as they can provide the necessary funds quickly and without significant financial strain on the business or the remaining owners.

Other options may include using personal funds, securing loans, or setting aside business profits in a sinking fund dedicated to this purpose. Each funding method has its merits and potential drawbacks, depending on the business structure and the owners’ personal financial situations. Careful consideration and a comprehensive risk management plan are essential to help ensure that the chosen funding mechanism is viable and sustainable for the long-term health of the business.

3. Triggering events

Triggering events are specific circumstances defined within a buy-sell agreement that initiate the buying and selling process. These events are crucial in determining when and how ownership transitions will occur, and they can include: 

  • Retirement
  • Termination of an owner
  • Death
  • Disability
  • Divorce
  • Personal desire to sell

It’s important that these triggering events are clearly outlined and agreed upon by all parties to prevent any misunderstandings or conflicts during transitions. Identifying and planning for these events in advance can help the business continue to operate smoothly and without disruption, regardless of unforeseen personal circumstances that may affect the owners. 

4. Restriction on transfer

Another important consideration when drafting a buy-sell agreement is the imposition of restrictions on the transfer of ownership interests. These restrictions serve to protect the business and its remaining owners by controlling who can become an owner and under what conditions. 

Typically, these restrictions prevent owners from selling their shares to outsiders without first offering them to existing co-owners, as outlined in agreements like right of first refusals. Implementing these restrictions ensures that the business remains within the control of the current owners or their chosen successors, maintaining the established operational and cultural ambiance of the business and minimizing the risks of entrepreneurship.

Are buy-sell agreements tax deductible?

The taxation of buy-sell agreement proceeds depends on many factors, including the structure of the business, the type of assets involved, the form of the transaction, and the terms of the agreement. Here’s a general overview of how buy-sell agreement proceeds are typically taxed.

  1. Type of business entity: C Corporations may be subject to corporate income tax on any gains realized from selling its assets as part of the buy-sell agreement. Shareholders who receive proceeds from the sale may be subject to capital gains tax on their share of the distribution. However, the gains and losses for S Corporations generally pass through to individual shareholders, who report these items on their tax returns. The proceeds are often treated as capital gains for the individual shareholders. 
  2. Types of assets: When selling tangible assets, the taxation of any gains or losses will depend on the characterization of those assets. For example, selling real estate or equipment may have different tax implications than selling inventory or other business assets. Note that taxation for the sale of ownership interests, such as shares of stock, generally follows the rules for capital gains. 
  3. Character of income: In many cases, proceeds are treated as capital gains for the recipients. The tax rates for capital gains vary based on factors like the holding period of the assets and the individual’s overall income.
  4. Basic adjustment: The tax basis of the assets or ownership interests can impact the calculation of capital gains or losses. A higher basis generally results in a lower taxable gain. 
  5. Installment sales: Payments are made over time per the terms of the buy-sell agreement. Tax treatment can differ depending on how it is structured, but typically, the recipient is taxed as funds are received. 
  6. Gift and estate taxes: If the buy-sell agreement is part of an estate planning strategy or involves gifts of ownership interests, gift and estate tax considerations may apply. Estate-specific exemptions and deductions may affect the overall tax liability. 

Although the specific tax treatment for buy-sell agreement proceeds can be exceedingly complex, and will vary based on individual circumstances and the terms of the agreement, it is crucial to properly document and report the transaction to the IRS using the appropriate tax forms and following tax regulations. Compliance with tax laws and regulations is essential to avoid potential penalties and work towards a smooth transition for the business.

What are the disadvantages of a buy-sell agreement?

Despite the numerous benefits of buy-sell agreements in providing clear succession planning for small businesses, they do not come without their potential drawbacks. One significant disadvantage is the potential for liquidity issues. For instance, if the agreement requires the company or remaining owners to buy out a departing owner’s share, there must be enough liquid assets available to cover the purchase without harming the business’s operational capacity. 

Disagreements over valuation can also arise, particularly if the agreement does not clearly define a fair and consistent method for valuing the business. This can lead to disputes among owners, potentially resulting in costly legal battles and damaging the business’s harmony and operations. 

Additionally, the agreement’s constraints may limit owners’ flexibility in transferring their ownership stakes, possibly affecting personal estate planning or overall financial strategies. Lastly, the cost of funding the agreement, especially through life insurance premiums or setting aside significant funds, can be substantial, which can have a sizable impact on the company’s overall financial plan and resource allocation.

Navigating the complexities of buy-sell agreements, from drafting the initial clauses to understanding the intricate tax implications, requires meticulous planning and broad, significant expertise. Without these you can wind up with a poorly designed agreement that fails to protect the business and its owners effectively. 

That’s why it is essential to consult with professionals like Avidian Wealth Solutions, who have extensive experience in creating buy-sell agreements and offering wealth planning for business owners for businesses of all sizes and structures. Together we can partner to create a buy-sell agreement that works to protect your interests and paves the way for continued success.

Schedule a conversation with us today to learn more about how we can assist in creating a buy-sell agreement for your business. While our physical offices are in Houston, Austin, Sugar Land, and The Woodlands, we can serve you no matter where you are in Texas.

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