Business owners: Now’s the time to revisit buy-sell agreements
Buy-sell agreements should be a crucial part of your estate and succession plans if you have a stake in a closely held company. These contracts outline how each owner’s interest will be handled promptly following a “triggering event.” Examples of triggering events include death, incapacity, divorce, or exit from the company. This allows or mandates that the business or the surviving owners buy the departing owner’s interest. Frequently, life insurance is the buyout.
What are buy-sell agreements?
Buy-sell agreements offer several significant advantages, such as:
- Maintaining ownership and control within a family or other close-knit group
- Creating a market for otherwise unmarketable interests
- Supplying cash to cover estate taxes and additional costs
A buy-sell agreement may even determine the worth of ownership interest for estate tax reasons. Yet, because circumstances might alter, it’s crucial to periodically examine your buy-sell agreement to ensure it still meets your needs. An ideal time to do this is the beginning of the new year.
Focus on the valuation provision
It’s crucial to check that the valuation clause of the agreement, which determines the purchase price for an owner’s interest, still accurately reflects the company’s market value.
Pay particular attention to the valuation clause when you go over your contract. When a triggering event happens, a valuation provision often takes one of three courses of action:
- Formulas, such as book value or a multiple of earnings or revenues as of a specified date
- Negotiated price
- Independent appraisal by one or more business valuation experts
In theory, negotiating a price can be a sensible strategy, but expecting owners to come to an understanding in tense, possibly hostile circumstances is asking a lot. One possible approach is to negotiate a price with a clause mandating an independent appraisal if the parties cannot agree on a price within a given time frame.
The most accurate valuations are typically those produced by independent evaluators. As conditions alter, formulas lose accuracy over time. For example, they may result in overpayments or underpayments if earnings have changed significantly since the valuation date.
Establish estate tax value
Both art and science are involved in valuing businesses. There may be some doubt regarding a firm’s valuation for estate tax reasons because the procedure is partly subjective.
Your heirs can be hit with unpleasant and unexpected tax obligations if the IRS later finds there was an understatement of your company’s value on the inheritance tax return. However, even if the business’s value is below fair market value in the eyes of the IRS, a well-crafted buy-sell agreement may be able to establish it for estate tax purposes, preventing unpleasant surprises.
To determine business value, a buy-sell agreement typically:
- Be a bona fide business arrangement
- Not be a “testamentary device” that transfers the business to family members or other heirs at a discounted value
- Have terms that are comparable to similar arm’s-length agreements
- Set a set price determinable from the agreement and is reasonable at the time of agreement execution
- Be binding during the owner’s life and at death and binding on the owner’s estate or heirs after death
A buy-sell agreement must comply with all of these conditions under IRS regulations if nonfamily owners hold at least 50% of the business’s worth. If you need assistance reviewing your buy-sell agreement, contact our RRBB accountants and advisors.
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