Buy-Sell Agreement

What Is A Buy-Sell Agreement? 

A Buy-Sell Agreement is relevant when you form a business with co-owners.  The Buy-Sell Agreement is a binding contract between co-owners of the business. The contract sets the terms and conditions of a future sale of one of the co-owners’ shares in the business once a triggering event occurs.  The purpose of Buy-Sell Agreements is to protect the remaining co-owners’ shares in the business from being depleted.

What Are Considered Triggering Events? 

Many Buy-Sell Agreements contain condition precedents before the duties and obligations under the contract are “triggered”.  For example, triggering events may include the death of one of the co-owners, divorce, disability, bankruptcy, or the separation of the business.

What Are The Different Types Of Buy-Sell Agreement?

Cross Purchase Agreement

A cross purchase agreement is a contract in which the co-owners agree to sell the leaving co-owners share at a set price.

Redemption Agreement

A redemption agreement is a contract amongst the co-owners in which they agree to use the money from a deceased co-owner’s life insurance to purchase the deceased co-owner’s interest in the business.

Hybrid Buy-Sell Agreement

A hybrid Buy-Sell Agreement consists of a combination of the cross-purchase agreement and the redemption agreement. A hybrid Buy-Sell Agreement is more flexible to the business or the remaining co-owners in buying the interest of the co-owner who is exiting the business.

Note:  It is important to remember that it is better to have a flexible payment method. To ensure that the business would still be able to buy out an owner when the company does not have all the money upfront to buy the share.

What Is A Mandatory Buy-Sell Agreement?

A mandatory Buy-Sell Agreement obligates the business or other co-owners to buy the leaving co-owners share. For this type of agreement it is recommended to buy life insurance to all partners in order to use that money to later pay for the co-owners share.

What Is An Optional Buy-Sell Agreement?

An optional Buy-Sell Agreement gives the right of first refusal to the business, co-owners, or third parties (such as spouse or children). 

Can A Former Spouse Of A Co-Owner Ask For Part Ownership Of The Business?

Each state is different, but here in California the former spouse can succeed in getting part ownership of the business. California is part of the “Community Property” states. Earnings and properties acquired during the marriage is considered community property. Each spouse can claim rights to community property. This means that all earnings and properties acquired with those earnings during the marriage belong equally to each spouse.

Does A Personal Bankruptcy Filed By A Co-Owner Affect The Business?

Yes, a personal bankruptcy could affect the business. Especially if the bankruptcy trustee liquidates (sells the assets) of the business in order to pay for the co-owner’s debt. To avoid this from happening, it is highly suggested  to include in the buy and sell agreement a requirement for the co-owners to notify the other owners when they want to file for bankruptcy. This requirement would include an agreement to buy the share of the bankrupted co-owner and with that money the co-owner would be able to pay the bankruptcy trustee.

Does A Buy-Sell Agreement Have An Effect On Estate Taxes?

Yes, a Buy-Sell Agreement can lower estate taxes in intergenerational businesses. A co-owner can leave its share in the business as inheritance to his family who will be active in the business. In this case, it is important to set a valuation formula in the Buy-Sell Agreement that will set the ownership interest at a lower value than its real value at the time of the owner’s death. This will help the owners’ relatives pay less estate taxes.

What Are The Benefits Of A Buy-Sell Agreement? 

A Buy and Sell agreement has many benefits.  The following is a list of benefits:

• Prevents departing co-owner from selling their share to a competing company.
• Establishes a funding formula to ensure the buyout, minimizing the risk of a business not having enough money to pay for the departing co-owners share.
• Resolves conflicts between remaining co-owners and the family of the departing co-owner of shared ownership.
• For intergenerational businesses, a buy and sell agreement can reduce the estate tax.
• Gives peace of mind to co-owners that the business will continue without conflict if a co-owner decides to leave.
• Ensures job stability to employees and co-owners.
• Avoids fracturization of management and voting control of the business.

Buy-Sell Agreement Checklist

Points to consider when writing a Buy-Sell Agreement include:

• Who owns the business?
• What events will trigger the Buy-Sell Agreement?
• Will the buyout be mandatory or optional?
• How will the value of the share be determined?
• How will the buy-out affect taxes?
• What will be the effects of  the buyout on the professional licensing requirements?
• Employee issues such as, compensation salary, or protection of  intellectual property
• Should mediation or arbitration be used in case of a co-owners dispute?

If the business is an S corporation, a Buy-Sell Agreement should include the necessary terms in order to not lose the status of S corporation. An S corporation is an ordinary business that decides “to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes” (www.irs.gov.com).

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