Unless you are the type who looks forward to going into business with your ex-partner’s spouse, most small and mid-size business owners need a written buy-sell agreement to prevent future problems.
No matter how small the business, when there are multiple business owners, it’s smart to have a binding buy-sell agreement which applies to everyone in the event of the death or disability of an owner, or disagreement among the co-owners. Even the best of friends can have major disagreements which threaten the future of a business. In fact, companies with co-owners who experience no conflict are rare. When the owner of a business dies or is disabled, or when the owners are feuding, the business can continue to operate if a binding buy-sell agreement is in place, to everyone’s benefit.
When death, disability or disagreement leads to the breakup of a business, it’s critical to have in writing who controls the business, who has the right to the future use of the business name and who has the right to compete with the business. In addition, it’s important to plan for assuring the funds to buy out a departing owner.
There are many specific advantages to having a buy-sell agreement among business owners which lays out how to transfer or dispose of the business on the occasion of a major dislocation.
One is that the buy-sell agreement guarantees a buyer for an asset which will probably never pay dividends to one’s heirs and would be hard to sell to outsiders. Among other advantages of a buy-sell agreement is the ability to spell out the terms of payment, and to fund them with life insurance or disability insurance, if appropriate. Another advantage is that it provides a smooth transition of complete control and ownership to those who are going to keep the business going. Funding a buy-sell agreement with life insurance owned by the buyer is more common than other funding methods, such as using the personal funds of the buyers, establishing a sinking fund in the business, borrowing the funds or making installment payments to heirs by the buyer. However, all are workable in appropriate cases.
One of the pluses to funding with life insurance is that complete financing is guaranteed from the beginning, which can be modified upward as the value of the business grows. In addition, proceeds can be made free from income tax. It can be a very economical method because discounted dollars are used. Also, cash values can be used for buy-outs due to retirement or disability, as well as strengthening a company’s credit position.
To have a buy-sell agreement respected by the Internal Revenue Service, the agreement must be a bona fide business arrangement. It cannot be merely a device to transfer the business to family members at less than full value. Finally, the terms of the agreement must be comparable to those found in similar arrangements entered into at arm’s length.