The Buy-Sell Agreement: Every Business Owner Should Have One

November 12, 2010 in Contracts

What happens if a business owner dies, withdraws from the business, or wants to sell his or her shares? Without a buy-sell agreement, the remaining owners can lose control of the business. The implementation of a buy-sell agreement, however, should be handled carefully. Having an improperly structured buy-sell agreement could be worse than having no buy-sell agreement at all.

A buy-sell agreement permits (or requires) the company or the remaining shareholders to buy back a departing shareholder’s stock. In addition to controlling ownership, a buy-sell agreement:

  • Creates liquidity for a deceased shareholder’s heirs.
  • Provides an “exit strategy” under which owners can withdraw from the business and dispose of their interests.
  • Helps avoid disputes over the value of stock by setting the price or a formula for determining the price.
  • Provides for an orderly succession of the business to family members or others.
  • Helps establish the value of the business for estate and gift tax purposes.

Buy-Sell Events

The obligation to buy or sell shares of a company typically is triggered by any one of the following events:

  • Death
  • Disability
  • Termination of Employment

In structuring a buy-sell agreement, careful consideration should be given to the circumstances under which a shareholder’s employment is terminated. A shareholder’s employment may be terminated by the company or by the shareholder. If the company terminates the employment, the termination shall may be “for cause” or “not for cause.” If the shareholder terminates his own employment voluntarily, the termination may be in the prime of his career or may be a termination in the nature of retirement. In most cases, each of the foregoing situations will call for a different set of buy-sell requirements.

In addition to the ordinary triggering events, a well-drafted buy-sell agreement also should address the bankruptcy or divorce of a shareholder.

Optional or Mandatory Purchase Requirement

For each triggering event under a buy-sell agreement, the agreement should specify whether the purchase of the departing shareholders shares is mandatory or optional. Many buy-sell agreements provide for a mandatory purchase in every situation. Quite often, however, that is not appropriate. For example, if a shareholder’s employment is terminated for cause, should the company or the remaining shareholders be forced to fund a large stock purchase? If the bankruptcy of a shareholder is addressed in a buy-sell agreement, the purchase of the bankrupt shareholder’s shares ordinarily should be optional.

Valuation of a Departing Shareholder’s Shares

Valuation of a departing shareholder’s shares is perhaps the most difficult part of structuring a buy-sell agreement. There are several options to consider. The buy-sell agreement can provide for an appraisal of the departing shareholder’s shares at the time of his or her departure. Alternatively, the buy-sell agreement can specify a formula for valuing a departing shareholder’s shares. A third option is to require the company and shareholders to agree on an annual basis what the value of a departing shareholder’s shares will be for the following year. Each valuation method has its advantages and disadvantages. For example, an appraisal requirement probably best ensures that both the remaining shareholders and the departing shareholder will be treated fairly. Appraisals, however, are expensive and the appraisal process is time consuming.

Dispute Resolution

Buy-Sell agreements can be used to implement an effective dispute resolution mechanism commonly known as a “forced buy-sell” or “shotgun buy-sell” arrangement. Under this arrangement, a shareholder may provide notice to another shareholder and state the price per share at which one will be required to buy the other’s stock. The other shareholder then is required to choose whether to be the buyer or seller at the stated price. This mechanism often allows co-shareholders who no longer get along with one another to sever their relationship in an efficient and fair manner, without the need for expensive appraisal or litigation.

Types of Buy-Sell Agreements

There are generally two types of buy-sell agreements: the cross-purchase agreement and the redemption agreement. Under a cross-purchase agreement, a departing shareholder’s stock is purchased by one or more of the other shareholders. Under a redemption agreement, the corporation purchases the stock. Often, buy-sell agreements are funded with insurance on the shareholders’ lives. If a redemption agreement is used, the corporation is the owner and beneficiary of the policy. Under a cross-purchase agreement, each shareholder purchases insurance on the lives of the other shareholders.

Although cross-purchase agreements are more difficult to administer, they may be advantageous tax wise, in two respects. First, if insurance is used to fund the purchase obligation, the purchasing shareholders essentially receive a stepped-up basis in the stock, which reduces the amount of capital gains tax they must pay if they sell the stock.

Suppose, for example, that Smith and Jones are the cofounders of ABC, Inc. Each contributes $10,000 to ABC in exchange for 50% of ABC’s stock. If ABC, Smith and Jones enter into a stock redemption agreement funded by $1,000,000 insurance policies on the lives of Smith and Jones and Smith dies when the value of the business is $2,000,000, ABC will collect the insurance proceeds and buy back Smith’s stock for $1,000,000. Jones then will own 100% of ABC’s outstanding stock, but his basis only will be $10,000. If Jones then sells his stock for $2,000,000, he will realize $1,990,000 in taxable gain.

If, instead, Smith and Jones enter into a cross purchase agreement, Jones will collect the insurance proceeds and purchase Smith’s shares, thereby increasing his tax basis to $1,010,000 (the purchase price plus his original capital contribution). If Jones sells his stock, his taxable gain will be only $990,000 rather than $1,990,000.

Second, cross-purchase agreements avoid alternative minimum tax (AMT) problems that sometime arise under redemption agreements. Life insurance proceeds generally are tax-free to the recipient, but a corporation may incur AMT liability as a result of receiving life insurance proceeds.

This article contains only general information and is not to be relied on as legal advice. For advice on your individual situation, consult a lawyer in your jurisdiction. No attorney/client relationship arises from use of this article.

Pre-Nuptial Agreements – Just In Case It’s Divorce That Does Us Part

April 28, 2005 in Contracts

Pre-Nuptial Agreements are being signed by more and more couples. They are not limited to couples dealing with financial inequality, or couples that have a lot of wealth. With half or more of all ending in divorce, Pre-Nuptial Agreements have become widely accepted as smart financial planning tools.

What is a Pre-Nuptial Agreement?

It may not be romantic to think about this way, but marriage essentially is a legal contract between two people. With regard to your property, the provisions of your marriage contract are governed by the laws of the state in which you live — and these laws determine how assets will be divided in case you divorce (or die) — unless you and your spouse decide you want to write your own marriage contract instead. That is where a Pre-Nuptial Agreement comes into play.

As its name implies, a Pre-Nuptial Agreement is an agreement between the couple who are contemplating marriage as to (i) what property is separate, pre-martial property, (ii) the character of property acquired during the course of the marriage, (iii) the division of property and marital obligations and such matters as spousal maintenance in the event of separation or divorce, and (iv) the handling of financial aspects of the marriage, such as payment of living expenses and preparation of income tax returns. A Pre-Nuptial Agreement can promote the well-being of the marriage, as it reduces the uncertainty each spouse may feel about financial matters.

Who should have a Pre-Nuptial Agreement?

“Pre-nups” have gained in popularity in recent years. Why? Until the 1960s, most couples married young with visions of building a life together from the bottom up. Typically, neither party brought much property to the union. Today, young Americans wait longer to marry, often after accumulating financial worth. Also, the rising divorce rate translates into more second marriages, which often involve children from previous marriages. Consequently, more people contemplating marriage have reason to be careful, in case things don’t work out.

Consider the following to determine whether a Pre-Nuptial Agreement may be for you:

  1. Do you have children from a previous marriage for whom you’d like to provide?
  2. Are you responsible for other family members, such as elderly parents or a disabled sibling?
  3. Are you the owner of or partner in a business? (In the event the marriage terminates, your spouse may have a claim to part of the business.)
  4. Will you inherit assets from your family that you would prefer to have remain in the family (not shared with the spouse) in the event of your divorce or death?
  5. Will one of you bring substantially more assets to the marriage?
  6. Will your spouse be giving up her career or acting primarily as support for you in your career or business as part of the marriage, and if so, what will be his or her compensation for doing so if the marriage ends?
  7. Do you or your fiancée have debts for which you wouldn’t like the other to be responsible?
  8. Will you or your spouse be supporting the other through college or schooling likely to lead to a lucrative line of work?
  9. Do you foresee a large increase in future income?

What does a Pre-Nuptial Agreement do?

A Pre-Nuptial Agreement in Arizona accomplish three basic things:

  1. It defines what constitutes separate property and what constitutes community property.
  2. It defines what constitutes separate debt and what constitutes community debt.
  3. It allows a couple to set terms for spousal support.

How is a Pre-Nuptial Agreement prepared?

The process for creating a Pre-Nuptial Agreement is fairly simple. You and your potential spouse decide what works for you and what stays with whom in the event your marriage doesn’t work out. The deal you strike will generally be respected by the law, but remember, this is a legal contract to which American contract law applies, and a divorce court can and will overturn you private agreement if it finds that:

  1. The agreement is likely to promote divorce — that is, it gives one or both parties a monetary incentive to leave;
  2. The agreement was written with the intention of divorce;
  3. One of the parties was coerced into signing the agreement; or
  4. The disclosure by one party was inadequate.

Perhaps the most important ingredient of a solid Pre-Nuptial Agreement is honesty. Both parties must FULLY disclose their assets. If it turns out either person has hidden something, whether or not intentionally, a judge can toss out the contract.

A Pre-Nuptial Agreement should be signed well in advance of the wedding. This avoids the appearance of coercion, which will cause an agreement to be invalid.

It’s best to do things formally. Without a formal contract, you could end up like director Steven Spielberg. Mr. Spielberg’s ex-wife got half of what he earned during their four-year marriage because their pre-nuptial agreement was scribbled on a napkin and she wasn’t represented by a lawyer. This “informality” cost Mr. Spielberg $100 million.

Things to Remember:

If you are considering a Pre-Nuptial Agreement, it is important to remember three things:

  1. Discuss the agreement early in the relationship. Don’t wait to say “pre-nup” until right before you say, “I do.”
  2. Be honest. Don’t try to hide your thoughts, feelings or assets.
  3. Hire separate attorneys so you both have good representation.

Couples should review their Pre-Nuptial Agreements every few years. Pre-Nuptial Agreements are written defensively, so after a certain number of years of wedded bliss, some of their provisions should be revisited.

Conclusion

Time have changed. Pre-Nuptial Agreements have a place in many marriages, especially second marriages. If you think you may need a Pre-Nuptial Agreement, don’t be afraid to raise the subject. A well conceived Pre-Nuptial Agreement won’t destroy a marriage – it will help protect it.

This article contains only general information and is not to be relied on as legal advice. For advice on your individual situation, consult a lawyer in your jurisdiction. No attorney/client relationship arises from use of this article.