3 Powerful Benefits of Funded Buy-Sell Agreements
Do you know what would happen to the accounting firm you work at if the owner (which may very well be you) passes away or decides to retire? Many practices utilize funded buy-sell agreements to ensure the business doesn't fall into the wrong hands. CPA Mark Pierce explains the benefits of this financial planning tool.
Private businesses have many safeguards in place to ensure that they remain independent after an event such as the death or retirement of an owner. It’s best to decide beforehand what would happen to this person’s shares in the company. How do they do this? The answer is funded buy-sell agreements.
Funded buy-sell agreements are how most closely held companies and private practices operate to ensure that the interest in the business doesn't fall into the hands of people the owners don't want holding it. Such an agreement delineates how a partner's share in a business will be distributed upon their departure or death. These agreements have a lot of weight in determining the final ownership percentages of a business.
The Purpose of a Buy-Sell Agreement
Buy-sell agreements often appear in business structures. They may be part of a shareholder agreement, partnership agreement, operating agreement or some other type. The primary purpose of the buy-sell agreement is threefold:
1. Makes ready buyers available to facilitate the sale of shares in the business
2. Limits ownership of shares to current holders and prevents the purchase of shares by third parties
3. Creates a funding mechanism after a triggering event so that the company isn't forced to sell illiquid assets when it doesn't need or want to
What's more, a well-designed buy-sell agreement can limit the taxes that the deceased's inheritors may need to pay out. While the sale of shares during the deceased's lifetime was completely taxable, the sale that happens after their death is non-taxable (since the selling entity is technically a non-taxable entity). Buy-sell agreements ensure that a business's owners retain most of the say in a firm without worrying about whether the leaving partner or their estate will sell off shares and dilute the company's ownership interest.
In the case of an accounting practice, there may be times when the owners need to cut ties with one of their members. For instance, an accountant may not be pulling their weight in the practice, or they might be antagonistic to other members. In such a case, triggering a buy-sell agreement to get them out of the practice is a viable option. Additionally, a firm without a buy-sell agreement written into its charter is likely to have to go to court to resolve the situation.
Difficulties in Buy-Sell Agreements
These agreements typically have selective triggering events. When a partner in the business dies or leaves the company, the agreement is triggered. However, the difficulty that stems from the agreement is how to value the company's shares. Depending on the agreement, the owner can choose multiple valuation methodologies, which may differ in cost and complexity. There are a few agreements that rely on annually set prices for the shares of the company. However, if the market is volatile or the business is growing, a price set at the start of the financial year may no longer be valid a mere few months after the fact.
An alternative and more dynamic method of calculating value comes from using the business's book value. Some companies prefer to use the business's market capitalization value. An excellent trade-off involves combining both of these valuation methods to come up with a figure. The most important thing is to get a viable price for the time window for the purchase. It would not do to over- or undervalue the business.
For accountants, the buy-sell agreement is triggered in one of four different situations:
- Death and Disqualification: If an accountant dies or is disqualified from practicing, then the accounting practice can buy back their portion of the firm’s shares. Life insurance is usually used to purchase the shares if the member dies.
- Disability: If an accountant becomes disabled to the point where they can no longer work, the practice can seek to buy back their shares using disability insurance. Barring insurance, the company may also issue a promissory note.
- Disputes: When you have a dispute within the firm, you may end up with accountants who can’t work together. In this situation, “shotgun” procedures are used – one accountant will offer to buy out the other’s shares. Regardless of who is the buyer and who is the seller, one accountant will inevitably leave the firm.
Specifying the Buyout Conditions
Once the triggering event occurs, the agreement is tasked with denoting how the buyout will happen. How does the buyer pay for the departing owner's shares? The most obvious method would be to leverage the business's cash and equity to buy the departing owner's shares from them or their executors. However, most companies don't have that amount of liquid assets and can't liquidate enough in a short space of time to make this a viable concept. The other option is to register a life insurance policy that's pegged to the owner's stake in the business. Depending on the business’s position, it may choose to have a life insurance policy over a series of years to ensure that there will be ample funds left to purchase their shares if the owner dies. However, the duration of coverage and whether the insurance company will even cover the owner are both decided based on their current age and state of health. Insurance companies routinely refuse to cover individuals over 85 for life insurance, for example.
Redemption and Cross-Purchases
Agreements may either be structured as a redemption purchase or a cross-purchase, but more often than not, they’re framed as a combination of both elements. In a redemption agreement, an "entity" is created that will be responsible for purchasing the former partner's share of the business. The entity will own life insurance policies for each of the partners to allow it the leverage to make the purchase. Once the purchases are made, those shares are no longer outstanding, and the interests of the remaining partners are increased to reflect the change in percentage ownership. The redemption is a simple method of dealing with a partner leaving and benefits from using the entity as a purchaser. The entity is separate and apart from the deceased's estate, meaning that their creditors cannot attack it for a settlement.
Cross-purchase agreements allow the remaining members of the company to acquire the shares from the deceased partner. In such a case, each owner individually owns the policy on the others' lives. When one owner dies, the remaining members get the proceeds of the life insurance policy, which they may then use to purchase the deceased member's shares. The cross-purchase agreement can get messy, so most businesses opt for a hybrid approach. This offers flexibility but at the same time ensures that the life insurance policy is used to rebuy those shares from the estate of the deceased. With the Biden administration's proposal to eliminate carryover basis, redemption agreements may become even more popular, since they aren't affected.
Funded Buy-Sell Agreements Are Useful
While there are several demonstrated benefits of both approaches to buy-sell agreements, each business is unique. Owners should get together and decide what they would like to see in their buy-sell agreements and which type of arrangement they'd prefer. While cross-purchase agreements offer value to shareholders, they may come under fire from the day's government. Redemption may offer a respite from persecution by the state, but it is far less flexible in how shares are redistributed after an owner's untimely demise. In such a situation, a discussion is critical to understanding how best to settle the business's future if one or more owners were to leave or perish.
Mark Pierce, CPA and attorney, is owner of Wyoming-based Cloud Peak Law Group. He has been an attorney for over 30 years. He graduated from the University of Wyoming with a degree in accounting (with honors) and passed the CPA examination shortly after. He previously served as a Bankruptcy Panel Trustee – administering over 1,000 cases.