Businesses with more than one substantial co-owner should have a buy-sell agreement. This agreement can help all parties when the inevitable happens, and one of the owners no longer can or will participate in the company as they had been. For the best result, your buy-sell should include a plan for what will happen when the following so-called “trigger events” occur.
Assume a company is owned equally by Lynn Jones and Greg Harris.They both work full time, contributing to the company’s growth, until Greg dies unexpectedly.
A buy-sell can set the stage for Lynn to buy the company shares that Greg’s wife will inherit. A predetermined formula can set the buyout price, which Lynn will pay, and some life insurance can provide the funds she’ll need. Alternatively, the company might receive the insurance proceeds and buy in Greg’s shares, leaving Lynn as the sole owner.
Dealing with disability
In another scenario, Lynn suffers a serious illness and cannot work. The buy-sell can spell out how disability will be determined, whether Lynn will receive a salary, how long such a salary will continue, and how an ultimate buyout will be structured. Disability insurance may help to provide the necessary funds.
Defending against divorce
Considering the U.S. divorce rate and the demands of running a small business, it’s not surprising when a company co-owner has marital problems. However, if Greg is in a divorce negotiation, his wife may want a share of the company as part of the settlement- and Lynn might not welcome this additional partner.
Such a situation can be avoided if share transfers are restricted in some manner by the buy-sell agreement; the divorcing co-owner, the non-divorcing owners, or the company might be
given the right of first refusal, so the divorcing spouse receives cash instead of shares. (Careful drafting is needed to avoid tax traps.) The buy-sell agreement should cover valuation,
and the owners should have a plan to generate enough cash.
Ready for retirement
In yet another scenario, Lynn decides that she wants to retire while she is
still young and healthy enough to enjoy her favorite pastimes. Greg intends to stay active in the business. A buy-sell can set up a plan in which Lynn steps down and is compensated for her interest in the company, perhaps over an extended time period. Some life insurance policies can be structured to fund such a contingency.
What if Lynn wants to leave the company at, say, age 55 in order to try another career A buy-sell agreement may distinguish between retirement and”withdrawal” or “departure;’ perhaps based on age. A buy-sell could discount the purchase price if an owner leaves after relatively few years and could delay the payout until a certain time, if that’s what the co owners agree upon.
Suppose that Greg incurs a tremendous amount of debt, either from extravagant living or from poor financial decisions not directly related to the company.He might file for personal bankruptcy to get relief. Again, the buy-sell can set a procedure for Lynn or the company to buy Greg’s shares so that his creditors get cash instead of interests in the business.
Time and money
Business owners commonly work long hours and need ample cash flow for company growth.Thus, owners of a small firm might not look forward to crafting a detailed buy-sell agreement, paying attorney fees, and committing to premium outlays for life insurance as well as disability insurance. That reluctance should be weighed against the outcome if one or more of the previously mentioned
trigger events should arise without a buy-sell in place. A deceased partner’s heirs may inherit shares without a procedure in place for an equitable buyout; an owner’s divorce negotiations might spill over and affect company operations.
Our office can help you develop a buy-sell agreement that will protect you, your co-owners and your company from getting hurt when the trigger is pulled on these types of events.
The CPA Client Bulletin (ISSN 1942-7271) is prepared by AICPA staff for the clients of its members and other practitioners. The Bulletin carries no official authority, and its contents should not be acted upon without professional advice. Copyright ©2014 by the American Institute of Certified Public Accountants, Inc., New York, NY 10036-8775.
In accordance with IRS Circular 230, this newsletter is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose.