What is the Advantage of a Buy-Sell Agreement?

A buy-sell agreement is a legally binding contract outlining a business owner’s plan for transferring control and ownership of their enterprise. It is often created in conjunction with estate planning, since the business is usually the owner’s most significant asset. A buy-sell agreement prepares the company to continue operations if and when the owner retires, becomes incapacitated, or dies, and is most commonly used by sole proprietorships, privately-held corporations and partnerships.

The buy-sell agreement typically involves the company owner, owners, shareholders, partners, and key employees. If family members work in the business, it is even more critical to have a buy-sell agreement. The family and the business might easily be embroiled in expensive, time-consuming litigation without a buy-sell agreement.

The buy-sell agreement must identify the parties involved, establish the trigger events, formalize the type of buy-sell structure used, how the transaction will be funded and address all taxation consequences.

Planning for Taxes Upon the Sale of a Business

The buy-sell agreement must align with both estate and tax planning. The sale of a business almost always leads to a long-term capital gain for the seller. There are also federal capital gains taxes, and, depending upon the state, there may be a state income tax on the capital gains. A business can be sold at a profit, only for those profits to evaporate because of taxes.

Common Structures of Buy-Sell Agreements

  • An entity-purchase agreement. The business entity and owners agree to have the business buy the owner’s interest at a triggering event (retirement, death, disability) at an agreed-upon price.
  • A cross-purchase agreement. A buy-sell agreement between business owners where the remaining owners agree to buy out the departing owner’s interest at an agreed-upon price when a trigger event occurs.
  • A hybrid or wait-and-see agreement. The buyer of the business isn’t identified in the agreement and could be the entity, other owners, or both. The buyers and the number of shares each will purchase are not determined until after a triggering event. The company has the first option to purchase the departing owner’s shares. If it doesn’t, the remaining owners may purchase the shares, but if they do not, the company itself is obligated to buy all the remaining shares.

Valuing the Business Before the Sale

An objective professional, usually a CPA with advanced valuation credentials, establishes the purchase price and valuation of shares. The value of any business fluctuates over time, so the agreement will include when the valuation should be done, which may be once when the agreement is first created and annually after that or at another designated time.

How is a Buy-Sell Agreement Different from a Succession Plan?

A buy-sell agreement is a legally binding contract setting forth the terms and conditions of a sale, while a succession plan focuses on the business operation and management. It’s a blueprint for how the company should be run, clarifying responsibilities for executives and managers and detailing how the enterprise will run during and after the transition to new ownership.

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