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The Importance of Reviewing your Company’s Buy-Sell Agreement

If you own a business and follow professional advice, you’ve likely established a buy-sell agreement in case you or a co-owner voluntarily or involuntarily leaves the company. Assuming this is true, remember that it’s not enough to draft an agreement and put it in a safe place. You need to review and perhaps revise the document periodically.

Problems solved

The primary purpose of every buy-sell agreement is to legally confer on the owners of a business or the business itself the right or obligation to buy a departing owner’s interest. But a well-crafted agreement can also help ensure that control of your business is restricted to specified individuals, such as current owners, select family members or upper-level managers.

Another purpose of a buy-sell agreement is to establish a price for the ownership interests. You should engage a qualified appraiser to estimate the value of those interests when first making a buy-sell agreement, and periodically thereafter to ensure the price keeps up with the growing (or shrinking) value of your company.

Estate planning is also a priority for many buy-sell agreements. If your agreement was drafted more than a few years ago, you may need to update it based on recent gift and estate tax changes. For 2017, the top rate for the gift, estate and generation-skipping transfer (GST) taxes is 40% and the exemption limit is $5.49 million. However, also keep in mind that the President and Republicans in Congress have indicated a desire to repeal the estate tax, which might happen later this year.

Standard and unusual triggers

Most buy-sell agreements lie dormant for years. What can quickly bring one to life is a “triggering event,” such as the injury or death of an owner, or, when one retires or voluntarily leaves the company. These are the major events that can bring a buy-sell agreement into play, but other occurrences such as changes to marital status can as well. Also, many agreements cover events such as conviction of a crime, losing a professional license or  certification, or becoming involved in some other situation that is deemed inappropriate or illegal.

Options for Structuring an Agreement

Buy-sell agreements typically are structured as one of the following agreements:

Redemption, which permits or requires the business as a whole to repurchase an owner’s interest,

Cross-purchase, which permits or requires the remaining owners of the company to buy the interest, typically on a pro rata basis,

Hybrid, combines the two preceding structures. A hybrid agreement, for example, might require a departing owner to first make a sale offer to the company and, if it declines, sell to the remaining individual owners.

In choosing your buy-sell agreement’s initial structure, consider the tax implications. They will differ based on whether your company is a flow-through entity or a C corporation.

Sources of Funds

Buy sell agreements require a funding source so that remaining owners can buy their former co-owner’s shares. Life insurance is probably the most common, but there are alternatives. If you company is cash-rich and confident in its ability to remain so, you could rely on your reserves. However, this could leave many businesses vulnerable to an unplanned cash shortfall. Another option is to create a “sinking fund” by setting aside money for paying out the agreement over time. Again, if your cash flow begins to suffer, you may not have enough funds when they become needed.

Keeping your buy-sell agreement updated requires some effort. That effort will pay off in saved time and prevented conflicts should a triggering event take place. Whether you have a current buy-sell agreement that could use some reviewing and updating or you need to begin to draft an agreement all together, contact H&M. We will be happy to assist you.