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If you own an interest in a closely held business, a buy-sell agreement should be a critical component of your estate and succession plans. These agreements provide for the orderly disposition of each owner’s interest after a “triggering event,” such as death, disability, divorce or withdrawal from the business. This is accomplished by permitting or requiring the company or the remaining owners to purchase the departing owner’s interest. Often, life insurance is used to fund the buyout.
Buy-sell agreements provide several important benefits, including keeping ownership and control within a family or other close-knit group, creating a market for otherwise unmarketable interests, and providing liquidity to pay estate taxes and other expenses. In some cases, a buy-sell agreement can even establish the value of an ownership interest for estate tax purposes.
However, because circumstances change, it’s important to review your buy-sell agreement periodically to ensure that it continues to meet your needs. The start of a new year is a good time to do this.
Focus on the valuation provision
It’s particularly critical to revisit the agreement’s valuation provision — the mechanism for setting the purchase price for an owner’s interest — to be sure that it reflects the current value of the business.
As you review your agreement, pay close attention to the valuation provision. Generally, a valuation provision follows one of these approaches when a triggering event occurs:
Independent appraisals almost always produce the most accurate valuations. Formulas tend to become less reliable over time as circumstances change and may lead to over- or underpayments if earnings have fluctuated substantially since the valuation date.
A negotiated price can be a good approach in theory, but expecting owners to reach an agreement under stressful, potentially adversarial conditions is asking a lot. One potential solution is to use a negotiated price but provide for an independent appraisal in the event the parties fail to agree on a price within a specified period.
Establish estate tax value
Business valuation is both an art and a science. Because the process is, to a certain extent, subjective, there can be some uncertainty over the value of a business for estate tax purposes.
If the IRS later determines that your business was undervalued on the estate tax return, your heirs may face unexpected — and unpleasant — tax liabilities. A carefully designed buy-sell agreement can, in some cases, establish the value of the business for estate tax purposes — even if it’s below fair market value in the eyes of the IRS — helping to avoid these surprises.
Generally, to establish business value, a buy-sell agreement must:
Under IRS regulations, a buy-sell agreement is deemed to meet all of these requirements if at least 50% of the business’s value is owned by nonfamily members.
Contact us at firstname.lastname@example.org or 651-631-0616 if you’re in need of help reviewing your buy-sell agreement.
Virginia Ryan provides trust, will, probate, and business law services to clients in Maplewood Minnesota, and the surrounding areas of North Oaks, White Bear Lake, Lake Elmo, Grant, Mahtomedi, Dellwood, Woodbury, Oakdale, Roseville, Little Canada, Shoreview, Vadnais Heights, St. Paul, Hugo, Lino Lakes, Stillwater.