Brothers Bob, Doug and Bruce owned a chain of furniture stores. When Bruce died unexpectedly, Bob and Doug were unsure of how to handle Bruce’s share of the family business. If the brothers had had a buy-sell agreement, the aftermath of Bruce’s death wouldn’t have been so complicated.

A buy-sell agreement provides for the disposition of each owner’s business interest after a “triggering event,” such as death, disability, divorce, termination of employment or withdrawal from the business. However, to be effective, the agreement must include the appropriate provisions.

Buy-sell agreement benefits

A buy-sell agreement gives the company or the remaining owners the right or the obligation to buy a departing owner’s interest. Properly structured, it restricts ownership or control to family members, management or some other select group, creates liquidity for a departing owner’s family to pay estate taxes (if applicable) and other expenses, and provides a market for otherwise unmarketable interests.

A buy-sell agreement can also help avoid disputes over ownership and control of the company when an owner leaves the business. In addition, in some cases, a buy-sell agreement can establish an ownership interest’s value for gift and estate tax purposes.

3 categories of agreements

A buy-sell agreement can fall into one of three general categories: redemption, cross-purchase or hybrid. A redemption agreement permits or requires the company to repurchase an owner’s interest. A cross-purchase agreement permits or requires the remaining owners to purchase the interest, usually on a pro-rata basis.

A hybrid agreement involves some combination of redemption and cross-purchase features. For example, it might require a selling owner or his or her representatives to first offer the interest to the company. If the company declines, the remaining owners are required to purchase the interest.

Typically, buy-sell agreements are funded using life insurance. On the death of an owner, the insurance provides a ready source of funds to purchase his or her shares. A properly structured funding arrangement will also provide for the liquidity needed on the retirement or disability of the owner.

The right type of buy-sell agreement for your business and the specific provisions that should be included depend on several tax and practical business factors.

Tax issues

From a tax perspective, cross-purchase agreements have an advantage, particularly if your business is organized as a C corporation. If a redemption agreement is funded by life insurance, the company’s receipt of insurance proceeds might trigger corporate alternative minimum tax.

Also, a redemption agreement boosts the value of the remaining C corporation owners’ shares without increasing their basis, which may result in higher taxes if they sell their interests. A cross-purchase, on the other hand, does increase basis, because the owner is purchasing additional shares.

Another tax concern for C corporations is constructive dividends. If a buy-sell agreement requires the remaining owners to purchase a departing owner’s shares, but they have the corporation redeem the shares instead, the purchase may be treated as a taxable dividend. You can avoid this result by making the corporation a party to the agreement and permitting, but not requiring, the remaining shareholders to buy back the stock.

For pass-through entities — such as S corporations or limited liability companies (LLCs) — the tax implications of redemption and cross-purchase agreements are usually roughly the same. Nevertheless, don’t overlook potential issues that may give rise to additional liability.

For example, if your S corporation used to be a C corporation and has accumulated earnings and profits, there could be some undesirable tax consequences. So, it’s important to review the specifics of your situation to ensure there are no lurking issues.

Valuation provisions

A buy-sell agreement’s valuation provision is critical. It sets the price — or establishes a method for calculating the price — that will be paid for a departing owner’s interest.

The most effective approach is to conduct regular appraisals to ensure that the price is fair and accurately reflects the value of the interest at the time it’s transferred. Some companies use valuation formulas tied to book value or earnings, but these formulas often lead to skewed results if the valuation is done at a time when the business is doing particularly well or, conversely, is going through a particularly difficult stretch.

Can a buy-sell agreement benefit you?

If you own interests in a family or closely held business, a buy-sell agreement may be right for you. Your estate planning advisor can give you more details.