As we discuss here, it is absolutely vital that small business owners plan ahead for the time when they can look back on all they’ve accomplished, leave their business in good hands, and reap the fruits of their labor in retirement.
In order to do that, a properly structured and drafted buy/sell agreement is a must. Here are three key aspects that should be addressed in any buy/sell agreement:
Valuation of Ownership Interests
A buy/sell agreement can be used to help establish estate and gift tax values for ownership interests. The fact that values can be set in advance in a buy/sell agreement can remove uncertainty and allow for advance planning. The values established in the agreement may also be less than might be determined if a buy/sell agreement were not used.
However, in order to have the buy/sell agreement values set estate tax values, the agreement must meet these four tests:
- The estate must be obligated to sell its ownership interest at the owner’s death;
- During life the owner was not free to sell their interest to anyone outside the agreement without first offering it to the other parties to the agreement;
- The agreement had a business purpose. (Keeping the business in the family meets this test);
- The terms of the agreement are similar to what would be acceptable in parties dealing with each other at arm’s length.
Funding the Buy/Sell Agreement
Finding the cash to buy the interest of a deceased, disabled, or retiring owner can be a major problem for a family business and for the other owners. As a result, the business and other owners often purchase life and/or disability insurance to fund the buy/sell agreement in the event of death or disability. In the case of a redemption agreement, the business will buy a policy on the life of each owner. In the case of a cross-purchase
Agreement, each owner will buy a policy on the life of each other owner.
The use of life insurance is not always an ideal vehicle, however. Although the proceeds are not taxed under the regular income tax, the proceeds may be subject to the alternative minimum tax. Also the cash value of the policy may not be sufficient to fund a buy back due to disability and retirement. In the case of disability or retirement, the ownership interest could be purchased on an installment basis. If the business accumulates cash to fund a future buyout, it is not a “permitted purpose” and could result in the imposition of the accumulated earnings tax.
Protecting Against Competition
A buy/sell agreement can also serve to protect the business from competition and loss of trade secrets and know-how when the owner sells his/her interest in the business. It can also protect a majority owner’s control or protect the interests of minority owners.
Voting agreements, irrevocable proxies and voting trusts can be part of a buy/sell agreement. A voting agreement is a contract between owners in which they agree to vote their interest to elect certain individuals as managing owners. An irrevocable proxy is an agreement in which one owner gives another owner the right to vote their ownership interest, or the right to vote for all other owners. A voting trust is an arrangement under which owners give up their voting right to a trustee who votes their ownership interests according to the terms of the trust agreement.
A buy/sell agreement is a good place to restrict a selling owner form leaving just to compete with the business once they have sold their interest. It is also a good place to provide for non-solicitation and non-servicing provisions. These provisions prevent a selling owner from soliciting existing business employees and existing business customers. Finally, a buy/sell agreement can be used to prevent a prior owner from using the company’s confidential information, trade secrets, and know-how to compete with the company after they leave.
A buy/sell agreement is a very useful, if not essential, business planning document. As there are several potentially complicated issues that can arise, it is highly recommended that you utilize the services of a qualified business attorney to ensure that the agreement is comprehensive and matches your business and personal goals.
Yee Law Group, PC, L.L.P.: Sacramento/Roseville Business Attorneys
Your business is our business. We partner with our business clients to provide them counsel they can rely on so they can focus on growing their business. The business world is fraught with challenges; your Roseville business attorney at Yee Law Group, PC LLP is ready to face those challenges with you head-on. If your business needs reliable, accessible, and personalized counsel, reach out to us at (916) 599-7297. We welcome the opportunity to help.
This article has been prepared by Yee Law Group, PC, PC for informational purposes only and does not, and is not intended to, constitute legal advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.