By Ginger Applegarth
After you die, what happens to the business you spent your life building? Setting up a buy-sell agreement could save your business.
If you own a closely held business, chances are that it takes up a big chunk of your balance sheet, even though most of its value can't be found in bank accounts and liquid investments. Have you ever stopped to think about what would happen to that business and its value if you die?
If you're wondering what to do, the answer is a "buy-sell" agreement. It can save your business and give your heirs a secure income.
If you don't do it, here's what could happen and has happened to thousands of small-business owners:
- If you have a sole proprietorship, the business shuts down because there is no one else in the business capable of (or interested in) running it. Additionally, when your heirs try to sell it, there aren't any buyers because you're not there to run it.
- If it's a partnership, the business continues, but those running it will have to pay someone to replace you, probably at a higher salary than you were paid because you were building equity. This puts a double strain on the business -- it is paying more to someone who knows less about your business and may require a long learning curve to get up to speed.
- A member of your family takes your place in your solely owned business but knows little or nothing about running it and it fails. Or, if you have a partner in a partnership or in a corporation with co-shareholders, replacing you with even a knowledgeable family member causes tension for the remaining co-owners. A family replacement can be more of a liability than an asset.
- The IRS determines that the value of your business is twice what you could sell it for and your estate has to pay taxes on that value even though there is little or no cash.
- Your family tries to sell your share of the business to your co-owners, but they don't have the money to buy it outright, and paying for it over a period of time would put a strain on the business's cash flow.
The bottom line? Your heirs kiss all or part of the value of your business goodbye. The money they were counting on to support them -- to pay for their retirement and perhaps for college -- will not exist. It will be even more painful if you had been planning to keep your business running until one of your children was old enough to take over.
What you can do
The solution to all of these scenarios is a binding buy-sell agreement that says if you die, someone else is obligated to buy your interest. That someone can be an actual person or people, such as current co-owners or even competitors. It could be the company itself.
With a buy-sell agreement in place, upon your death your estate can sell the business and receive the cash, the business won't go down the tubes, and you may have saved the livelihood of your partners or co-shareholders.
A key point to setting up the transaction correctly is to make the buy-sell agreement binding for all parties, so the buyers don't have the option of backing out after your death. Also, if done correctly, the IRS has to accept the value of the business interest that has been stated in the agreement.
Here's how to set up a buy-sell agreement:
- Hire an attorney who specializes in working with owners of closely held businesses. You need special estate planning anyway, and the structure and wording of a buy-sell agreement must be exactly right to make it binding and for the IRS to agree to the price.
- Have a professional appraise the business's value. Your attorney can probably give you the name of a good appraiser. Usually, the future buyer(s) will also have a professional appraisal performed. The numbers will not be the same. Count on it. Have your attorney negotiate with your future buyer's attorney about price. That way, the day-to-day affairs of the business won't be tension-filled, especially if you and the buyer(s) work together now. The IRS likes to see more than one valuation anyway.
- Use a cross-purchase agreement or an entity agreement? If the company is a sole proprietorship or partnership, the buy-sell agreement will usually be a cross-purchase agreement. If you own part or the entire corporation, your attorney will advise you whether it's better to have a cross-purchase agreement or an entity agreement.
- Decide how the purchase is going to be funded. Most small companies don't have large amounts of cash sitting around to buy a deceased owner's interest, and payments made over time can be a huge drain on cash flow. This is one reason why life insurance is almost always used to fund buy-sell agreements. When purchasing this life insurance, deal only with a life insurance agent who specializes in estate planning for closely held business owners.
- Write it down. Your lawyer (or your buyer's lawyer) drafts the buy-sell agreement; all parties review it and make any modifications needed to obtain approval on all sides. Your life insurance agent should be able to provide sample agreements that have been rigorously analyzed by teams of expert lawyers; most large insurance companies provide these for free.
- All buyers and sellers agree and sign the agreement. Hopefully, all of the insurance is approved and the funding is in place. If someone is turned down for insurance, modifications will have to be made in the agreement for other methods of funding. But if one party is declined for insurance, don't give up; find an agent who specializes in obtaining life insurance for individuals with medical problems.
The costs involved in a buy-sell agreement include professional fees and insurance premiums, but these costs are minor and well worth it in the end. After all, the alternative could be a big fat zero for your family; not only would they lack the money they were counting on, they would wonder why you did not "take care of business" while you were alive. In the end, if all is done properly, the life insurance proceeds will go to your estate, your new buyers will receive your interest and the business will carry on without a cash drain for years to come.
Your heirs and business partners will thank you.
Reproduced with permission of MSN Money.com, from Keep your business around when you aren't, Ginger Applegarth, 2007 ; permission conveyed through Copyright Clearance Center, Inc.