Buy-Sell Agreements Offer Hedge Against Unforeseen

Entrepreneur’s Notebook by Jeffrey D. Lewis

Disaster strikes, your business partner unexpectedly dies. Much to your surprise, you have just inherited a new partner: your deceased partner’s spouse.

Many business owners face this situation every year and some become enmeshed in lengthy and bitter disputes. Spouses can sue for their spouse’s salary in order to pay their living expenses; they can sue for an accounting of the income and expenses of each of their co-owned companies; and they can sue for the forced sale or liquidation of all their companies.

These lawsuits, and the subsequent countersuits, can badly disrupt the on-going businesses, decimate the previously close personal relationships between the parties, and cost them hundreds of thousands of dollars in legal fees.

Partnerships, corporations and limited liability corporations can be protected from these problems by creating a valid buy-sell agreement among all owners. Make sure any agreement reflects the current status and value of the business, and that owners’ wills and trusts obligate executors and trustees to implement the buy-sell agreement.

A buy-sell agreement is when one co-owner buys out the other co-owner (or his or her estate) upon the occurrence of certain specified events, generally some type of voluntary or involuntary withdrawal from the business.

There are two types of buy-sell agreements: a cross-purchase agreement and a redemption agreement. In a cross-purchase agreement, each remaining co-owner purchases a prorated share of the withdrawing co-owner’s interest in the business. A redemption agreement differs only in that the purchaser is the company rather than the individual co-owners.

Income tax savings

A major benefit of a cross-purchase buy-sell is that each of the remaining co-owners receives an increase in his or her basis in the company as a result of the purchase of the withdrawing co-owner’s interest. Since this does not occur in the redemption situation, the cross-purchase buy-sell can save significant income tax in the event the business is sold in the future.

The types of triggering events that should be considered by owners for inclusion in a buy-sell agreement are: death of a co-owner, total or partial disability of the co-owner (he or she is no longer able to function in the business as before the disability), and the withdrawal or retirement of the co-owner.

Each of these buy-out situations, except for withdrawal or retirement, can be paid through the purchase of life insurance or disability buy-out insurance. If no insurance is purchased or if the insurance proceeds are less than the purchase price, the agreement should provide for an installment payment of the balance of the price, with a stated interest rate.

Too often, even when a buy-sell agreement has been put in place, the co-owners file it in a desk drawer and don’t look at it again until a triggering event has occurred, often many years after it was first drafted. This results in an agreement that does not reflect the current ownership of the business. Some of the original co-owners may have left the company or new co-owners may have joined the enterprise. It is therefore important to periodically review the buy-sell agreement and ensure that it reflects the current circumstance and desires of the business and its co-owners.

The most frequent and devastating problem in an out-of-date buy-sell agreement is a purchase price that does not reflect the current value of the business. Think of the impact of you or your estate being forced to sell your interest in your business at a value that is 10 or 15 years old. While the remaining co-owners would be ecstatic, the withdrawing co-owner, his or her estate, spouse or children, would be left with a significantly reduced value for their interest in the business. One way to avoid this problem is to build a formula into the agreement that calculates the value of the business based on objective information, such as gross revenues, profits, book value, or a valuation by an independent third-party appraiser.

Consistency with will

Even if you have a buy-sell agreement with current information and valuations, you need to ensure that your estate plan is consistent with terms of the agreement. Don’t create a buy-sell agreement and then have an inconsistent provision in your will or living trust that distributes your interest in the business to your children. This will only create problems, disharmony, and potential lawsuits.

In order to avoid probate administration (a lengthy, costly, and public process) the business interest should be held by the owner’s living trust. In the event the business is a professional practice (such as a medical, dental, accounting, or legal business) the trust cannot own the interest unless one of the trustees is a “licensed person.” In those situations, the trust must make specific provision for the appointment of a licensed individual as special trustee to implement the sale of the interest in the business upon the death of the owner.

Clearly, co-owners can avoid unintended consequences with some simple advance planning, which can leave surviving spouses financially secure and minimize the potential for conflicts. Failure to act may subject you, your business, your partners, and your survivors to unnecessary turmoil and financial hardship.

Jeffrey Lewis is a partner with the law firm of Reish Luftman McDaniel & Reicher in West Los Angeles. He can be reached at .

Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.