Structuring your business can be challenging, and there are many points to consider when protecting your investment. The sudden death or disability of a key shareholder could drastically change or even destroy the business. It is vital to protect your business against this possibility. Using a buy-sell agreement is one way to do this.
Buy-sell agreements are essential to many types of businesses. They are complicated legal documents with critical legal and tax implications and doing your research and seeking expert advice is critical. Read on to learn more about buy-sells and contact the experts at Hometown Life Insurance for more information.
What are Buy-Sell Agreements?
Buy-sell agreements are legal contracts that businesses use to protect the corporation’s interests and the shareholders if one shareholder departs the company – either through retirement, death, disability, a new opportunity, or to resolve conflicts with other shareholders.
A buy-sell agreement does many things to protect the shareholders’ interests in the event of a shareholder’s death or another qualifying event. Specifically, the agreement:
- Provides direction as to how shares and business interests will be handled and identify such details as the purchase price and specific terms of sale
- Gives creditors, employees, and other shareholders peace of mind by knowing how transitions will occur and what happens when the leadership structure changes
- Reduces disagreements and potential lawsuits over how shares are distributed, sold, or retained following the departure of a shareholder
- Protects the finances and interests of the business and all shareholders, including the departing partner or their estate
When is a Buy-Sell Used?
A buy-sell agreement may be used in any corporation with more than one shareholder. It is a sound business practice to utilize the deal once more than one shareholder is involved in the organization’s leadership. This protects all parties, and most importantly, it protects the business when there are unexpected changes to leadership or organizational structure.
Unanimous Shareholder’s Agreement
A buy-sell agreement can be a stand-alone document or included as one part of the larger shareholder’s agreement. Determining where to include the buy-sell agreement or amendments to it can have tax and legal implications. Be sure to talk to your tax advisor or the experts at Hometown Life Insurance for more information.
What are the Crucial Points to Include in a Buy-Sell Agreement?
While every business has different needs, there are several general points to cover in a buy-sell agreement:
- Define events that trigger the agreement – Be specific in your definitions as you describe the qualifying events. Death and disability are common to include, but how do you define disability? What percentage or permanency of disability is required to enact the buy-sell agreement?
- Living buy-out – A living buy-out is caused by a partner moving on from the business for many reasons, such as retirement. The conflict between shareholders may be included in this section and detailed as to how shares are transferred.
- Bankruptcy – If a shareholder becomes insolvent, it is critical to detail the next steps to protect the business and the remaining shareholders. If creditors can pursue the other shareholders or sell the insolvent partner’s shares on the open market, that can adversely affect the remaining shareholders and the business in general.
- Divorce – The divorce of a shareholder could cause the distribution of marital property, including shares in the business. This could create a situation where the divorced spouse is now a shareholder with voting and other business rights. The buy-sell agreement can help protect the remaining shareholders in this situation by determining how shares will be handled in the case of divorce. The divorcing shareholder may have to buy their spouse out as the shares could be considered marital assets in some states. This buy-out can be detailed in the buy-sell agreement, as well.
- Division of shares – The buy-sell agreement should outline the shares remaining shareholders may purchase – or are obligated to buy. As well, it should detail under what circumstances may shares be sold to the public.
- Inter Vivos sale – An inter vivos transfer or sale occurs between living parties – this happens when a shareholder moves on from the business for a reason other than their death. The provisions and terms outlining how inter vivos sales will be handled should be included in the buy-sell agreement.
- Valuation – The method with which shares will be valued when the buy-sell agreement is triggered is essential to detail, whether it be a formula-driven fixed price or a method to calculate current market value. The government provides tax guidance on the implications of various valuation methods on the business, remaining shareholders, and the departed partner’s estate.
Funding a Buy-Sell Agreement
An essential part of any buy-sell agreement is determining how the deal will be funded. If the agreement is triggered, the purchase of shares from the departing shareholder could be expensive. Therefore, a plan must be in place to fund the buy-sell.
One common way to fund a buy-sell agreement is through life insurance, either a corporation’s policy or a personal one paid for by each shareholder individually. Because it is a relatively inexpensive way to fund the buy-sell agreement, life insurance tends to be frequently used.
Funding could also be secured through a bank loan or by establishing an account to self-fund the buy-sell. Both methods constrain capital, however. It may be challenging to accrue sufficient funds through a self-funded account before needed, especially if a shareholder departs prematurely. Securing a bank loan could be risky as well – there is the possibility it will not be approved or approved with unattractive terms.
Finally, an installment plan could be detailed in the agreement, providing for the distribution of shares to the estate over a set period of time.
How do I Learn More?
Now that you know more about buy-sells, you can contact Hometown Life Insurance experts for more information. Our licensed professionals will be happy to answer any questions you have.
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