Buy-sell agreements furnish guidelines for establishing the selling price of an owner’s interest in a closely-held business and to set a value of such interest for estate tax purposes. The agreement is a contract amongst the owners (as with a cross purchase arrangement) or with the business itself (as with a redemption arrangement) which restricts transferability of the ownership interest and provides for the sale price and terms of the sale of the business interest.
It is important to note that while a buy-sell agreement is important in establishing the sale price of an ownership interest for an estate, the IRS will disregard the agreement when valuing the ownership interest unless the following requirements are met:
- The agreement is between people who own more than 50% of the value of the ownership interest and who are not members of the seller’s family.
or
- The agreement was entered into as a business arrangement, such as retaining a key employee, and
- The agreement must not be part of a plan to transfer property to a family member at less than fair market value.
The rules to establish an agreement which is acceptable to the IRS for estate/gift tax purposes are extremely complex and should be reviewed with your tax advisor.
Other goals and benefits of a buy-sell agreement include creating a market and cash for the ownership interest at an agreed upon sales price and facilitating transition of the ownership.
Another advantage of a buy-sell agreement is that such agreements are typically funded through life insurance which avoids a large cash outlay. A disadvantage of a buy-sell agreement is the effect it may have on discounts used in family limited partnerships or other arrangements. As previously mentioned, buy-sell arrangements are typically with the business itself, as a redemption agreement or with the other business owners, as a cross purchase agreement. Each type of arrangement has benefits and disadvantages which need to be evaluated separately.
There are various valuation provisions used in a buy-sell agreement which generally fit into four basic categories. The first category consists of leaving the price to be determined in the future such as fair market value on date of death, or best offer received, or the value ultimately established for estate purposes.
A second category provides for appraisal or arbitration, involving an independent third party, at some date approximate to the event triggering the buy-sell.
A third category sets out different formulas to be applied to the financial statements of the business. For example, a provision of this type might provide for the price to be net book value or a multiple of earnings.
A fourth category consists of various fixed price agreed upon values. A fixed price provision provides the greatest amount of certainty and the fairest valuation as long as it is updated frequently. Certainty results from a stated fixed price which all parties can rely upon without a disputed interpretation.
In all categories, it is recommended that business owners use knowledgeable professional advisors to assist them in establishing the method of determining the value. Qualified appraisers can help in the initial valuation. Appraisals are not necessarily expensive and can result in an independent accurate valuation. Routine updates are generally less costly.
Drafting and implementing a buy-sell agreement is not a boilerplate process. Without a properly planned and drafted buy-sell agreement, the business that the owner has worked hard for may lose value.
By: Eliot H. Rosenwald, C.P.A., C.V.A.
Michael Silver & Company
Certified Public Accountants
For additional information or to have Eliot answer your questions call Rainmakers at 847/251-3327