In a previous Legal Brief, we discussed the importance of a business having a buy-sell agreement. Buy-sell agreements are an important part of business succession plans. Companies without one can find themselves in a tough position if something happens to one of the owners.
A buy-sell agreement is an important part of succession planning for business owners. It establishes their rights between each other and the business. Let’s focus on trigger events which put the buy-sell agreement into motion. Common triggering events are death, retirement, or one of the owners becomes disabled and can’t work.
There is another triggering event for buy-sells that is becoming more and more important. They are what we refer to as “involuntary withdrawal events.” Examples of these “involuntary withdrawal events” are when a third party seeks someone’s ownership interest in a company as a result of a divorce (the ex-spouse seeks the asset in the divorce), personal bankruptcy of the business owner (the bankruptcy trustee gains possession of the ownership interest and may use it to satisfy a creditor of the bankrupt business owner) or the business owner is sued for anything (car wreck, etc.) and the judgment creditor in the lawsuit seeks the ownership interest as satisfaction of the monetary award in the lawsuit.
Obviously, a partner in a business doesn’t want to be in business with an ex-spouse or any kind of creditor of their partner. So, a properly drawn buy-sell provides a mechanism whereby the business owner/partner who is not going through the involuntary withdrawal event can purchase the other’s ownership interest in order to avoid such a result. This is more of an asset protection feature than a tax or succession planning feature, but with the economic hardship of late and the increased litigiousness of our society, is becoming more and more important.
There are three different types of buy-sell agreements.
First is a cross-purchase agreement.
With this agreement, two or more owners or outside entities purchase the ownership interest directly from the withdrawing party or from the estate of the deceased individual. To fund the agreement, each shareholder buys life insurance on the other owner and names himself or herself as beneficiary of the policy. After the death of one of the owners, the surviving owners buy the shares. The surviving shareholders will then own 100 percent of the corporation.
The next type is the entity-purchase agreement.
In an entity-purchase agreement, the corporation agrees to purchase the interest of a deceased or departing owner. In this case, the corporation buys life insurance on each shareholder and names itself as beneficiary. The corporation receives the life insurance proceeds upon the death of one of the shareholders which funds the purchase of shares owned by a departing shareholder or the estate of the deceased shareholder. The surviving shareholders own 100 percent of the corporation as a result of owning all the shares that remain outstanding after the corporation redeems the shares of the former shareholder.
Then you have a hybrid agreement.
As you can guess, the hybrid agreement uses aspects of the entity-purchase agreement and the cross-purchase agreement. It often leaves the option of who the buyer is until a triggering event occurs. It gives a business an option to buy all or part of the interest of a departing owner.
Another flexible approach is to give the other owners an option to buy shares or partnership interest, and then obligate the entity to buy any interest not purchased by the remaining owners. The parties may also consider periodic reviews and updates of the buy-sell plan.