Law Offices of David J. Harter

A Professional Corporation

Articles: Buy-Sell Agreements*

If your business organization is a closely held corporation or partnership in which ownership and management largely coincide, a buy-sell agreement now can prevent problems later.

What Is A Buy-Sell Agreement?

A buy-sell agreement allows the remaining owners to acquire the interest of a withdrawing shareholder or partner. The agreement usually restricts an owner's ability to transfer his shares and it also provides the terms under which the entity or other owners may or must acquire a departing owner's interest on death or other specified events.

Why Should You Have a Buy-Sell Agreement?

• To prevent outsiders or heirs, whose interests may conflict with those of the remaining owners, from obtaining an ownership interest;

• To ensure the continued legal existence of the entity on the death, withdrawal, bankruptcy or expulsion of an owner;

• To ensure continuity of management;

• To increase job stability for minority owner and key non-owner employees;

• To provide for the orderly liquidation of the owner's interests in the event of forced or voluntary withdrawal;

• To prevent the continued involvement in the business of retired or inactive shareholders or partners;

• To create a market for the shares of deceased, retiring or withdrawing shareholders or partners;

• To provide cash to pay death taxes and estate settlement costs;

• To fix the value of the interest, including a minority discount for estate and gift tax purposes; and

• To prevent the loss of an S corporation status by preventing a transfer of the interest to an unqualified shareholder or to a shareholder who refuses to elect S corporation status.

When Does A Buy-Sell Agreement Go Into Effect?

• On an attempt to sell: When a shareholder or a partner seeks to sell his or her interest in the business, the business entity can retain a right of first refusal on the same terms as the third-party offer or at a price set in the buy-sell agreement.

• On Death: The death of a shareholder or partner triggers an obligation in the agreement to purchase the decedent's interest; purchasers would be the entity or the surviving shareholders or partners.

• On Retirement: The agreement may provide that shareholders or partners who are active in the business may or shall retire at a certain age or after a specified period of service, with their interest being purchased by the entity or the other owners.

• On Disability: The disability of a shareholder or partner who has been active in the business may trigger a buy out. The agreement would define "disability" and the means of determining the disability.

• On Expulsion or Termination of Employment: A partner or a shareholder's voluntary termination of employment or expulsion from the business may trigger a buy out.

• On Bankruptcy: An owner's bankruptcy or assignment for the benefit of creditors may also trigger a buy out.

• On Loss of License or Death of Licensee: Loss of a professional license by a shareholder or partner of a professional corporation or partnership usually triggers a mandatory buy-sell obligation, to assure continued compliance with professional corporation and licensing statutes.

• On Attempt at Dissolution: The agreement may also provide for buy-sell rights if the corporation is the subject of a voluntary or involuntary dissolution attempt.

Funding a Buy-Sell Agreement with Insurance

A crucial issue for a closely held business that wishes to buy out one of its principal owners is whether it will have the funds to do so. Because so few businesses have sufficient cash or other resources to fund a buy out, the seller usually must accept an installment payout and continue to share the risks of the future profitability of the business, unless the business has provided for a fund to buy out a major owner. There are essentially three methods for funding a buy out: (1) borrowing from a party, (2) setting up a sinking fund or reserve, or (3) acquiring insurance.

A corporation's obligation to purchase a shareholder's shares under a buy-sell agreement may be funded by the proceeds of, or loans against, the life insurance policy. The corporation usually owns, pays the premiums on, and is named as the beneficiary of the life insurance policy that funds its buy-sell obligation. In some instances, the insured shareholder or his or her estate may be designated as the beneficiary.

Whether life insurance should be used to fund a buy out depends on the nature of the business, the owners' objectives, the buy-sell prices for the owners' interests, and the cost of life insurance, including taxes. These factors will differ according to the type of buy-sell agreement used.