Charles R. Kennedy, CPA, MBA
Vice President & Director of Tax Services

The year end is a time for business owners to review many aspects of their business to ensure that their tax position, operational plans, financial management and workforce status are on track to help the company meet its long-term goals.

But one vital piece of a multi-partner business is often missing from the year-end review, and it holds the key to a smooth transition if one of the owners dies or elects to leave the business in the coming year – the buy-sell agreement.   

Buy-Sell Agreements

A buy-sell agreement is a contract that spells out numerous points of agreement among shareholders about a partner’s share of the business would be reassigned if the partner were to die or leave the business.

Think of a buy-sell agreement as a will for your business because it functions much like you will does in your personal life. The big difference, though, is that it not only stipulates your personal wishes, but also the agreed-upon intentions of all partners in the business.

Buy-sell agreements are crucial for businesses with multiple partners. Here are some key reasons why they are important:

• Buy-sell agreements ensure business continuity by providing a clear plan for the transfer of ownership if a partner leaves the business due to retirement, disability, death or other reasons. This contributes to the stability and continuity of the business.
• Buy-sell agreements prevent disputes among the remaining partners or a deceased partner’s heirs by outlining the terms and conditions for the sale of the departed owner’s interest.
• These agreements typically include a method for valuing the business, establishing fair value so the departing partner or their estate receives a fair price.
• Buy-sell agreements can help prevent unwanted parties – i.e., an heir of a deceased partner – from gaining ownership stakes, safeguarding the remaining owners’ control over the company and its ownership.
• These agreements also facilitate smooth non-disruptive transitions even if a partner’s departure is unexpected.

Ideally, buy-sell agreements are created at the time a partnership comes together. But that is not always the case, and a buy-sell agreement can be written at any time. A buy-sell is particularly important in cases where partners have put different levels of investment into the business or where one partner is much older than another.

Types of Buy-Sell Agreements

There are several types of buy-sell agreements, each with its own unique structure and purpose. Here are the main ones:

• Cross-Purchase Agreement – Each shareholder agrees to buy a portion of the departing shareholder’s share. These are good agreements for small businesses with few owners, as they are simple and direct. They can become overly complex in a business with many partners, as each must buy insurance on the others.
• Entity-Purchase Agreement (Redemption Agreement) – The business entity itself buys the departing shareholder’s share. These agreements are best for larger businesses with many shareholders, as they simplify the process with the business handling the purchase. One disadvantage is that this type of agreement may have tax implications for the business.
• Wait-and-See Agreement – This type of agreement combines elements of both cross-purchase and entity-purchase agreements. The business and the remaining owners decide who will buy the shares after the triggering event. This type of agreement is good for businesses that want flexibility, but can be more complex to draft and execute.
• Hybrid Agreement – This is a combination of cross-purchase and entity-purchase agreements, where the business has the first option to buy the shares, and if it declines, the remaining owners can purchase them. This type of arrangement appeals to businesses that are looking for a balanced approach or flexibility. However, it requires careful planning and clear terms.

Each type of agreement has advantages and potential drawbacks, so it’s important to work with an advisor and choose the one that best fits your business’s needs and goals. Consulting with a legal or financial advisor can help ensure you select and properly implement the right agreement.

Updating an Existing Buy-Sell Agreement

Once a buy-sell agreement is in place, it should be periodically reviewed and, if necessary, amended to reflect changes in business value, changes in ownership, life events such as the death, divorce or retirement of a shareholder, or changes in legal, financial and regulatory compliance. Additionally, a periodic review should include a discussion to ensure that the agreement is adequately funded, usually through life insurance or other financial instruments.

If you would like to discuss a buy-sell agreement for your company, contact your G.T. Reilly advisor.