BUY-SELL AGREEMENT ENSURES SURVIVAL OF SMALL BUSINESSES

By Jim W. Norman, CPA

jim@njcocpa.com

 

      Many business owners and their families have discovered the hard way that an essential survival tool for a closely held business is a buy-sell agreement. Such an agreement between the owners of a company allows for a smooth transfer of ownership upon the death or disability of one of the owners. Planning ahead for occurrences such as these can minimize business risk.

    There are two basic kinds of buy-sell agreements: nonfunded and funded. This column will focus on nonfunded buy-sell agreements.

    Owners may be underestimating their importance to the business by not protecting it in the event of their death or disability. The business would suffer from a loss in productivity, while the remaining partner(s) could still be paying a percentage of the profits to the heirs. The company might not survive such a shift in responsibility and loss of resources.

    Buy-sell agreements ensure that the stock of a deceased or withdrawing shareholder will not be sold to an outside third party before the other shareholder(s) have a chance to buy it. Without a buy-sell agreement, the heirs of the deceased can technically sell their shares of the business to anyone, including family members of the deceased, parties who are not qualified to run the business or even to the competition. Important decisions like hiring and firing, changing salary levels, as well as when to pay dividends, could be influenced by forces outside of the remaining partners' control.

    A buy-sell agreement can provide a market for the stock of each shareholder in the event of death, disability, or retirement. It can be used to establish the value of the business for the IRS and for estate planning purposes. Therefore, these factors have important tax implications for business owners.

    Preparing a business valuation helps in the estate planning process. Without a business valuation or a formula for calculating the business value, the IRS will tax the estate on the basis of its own business valuation, which can be much more costly. Normally, businesses use a general business valuation model to calculate the value. The buy-sell agreement should recommend that the valuation be updated on an annual basis.

    Although a nonfunded buy-sell agreement does not provide for the accumulation of funds or acquisition of insurance to cover the cost of transference, it is still a valuable business and estate planning tool. It states the intention to continue the business after the death or disability of the owner and places an agreed-upon value on the business.

    In order to avoid unnecessary hardship on family and colleagues, the buy-sell agreement should answer as many questions as possible, including setting a time frame for the transference of ownership, naming the key owners and specifying each one's percentage of ownership, and outlining all privileges and rights granted to key owners.

    Disability issues can be even more complicated than an owner's death. Statistics show that during their working lives, individuals are more likely to become disabled than they are to die. A disabled owner may still be legally entitled to receive a salary.

    As a result, the business may suffer the loss of a productive employee and the corresponding loss in the revenue they generated. It may be possible to hire a replacement for the disabled owner. However, then the business will be paying two people while only receiving the work of one. How long can a business and its remaining owner(s) afford to do this?

    For all of these reasons, it is important to include the issue of disability in the buy-sell agreement. For the maximum benefit, the agreement may often state that if an owner is disabled for more than a specified number of months, the disabled owner will agree to sell the company back to remaining owner(s).

    For a smoother transition of business ownership upon death or disability, now is the time to formalize your plans with a Buy-Sell Agreement.    

Jim W. Norman, CPA is a principal with Norman, Johnson & Co., PA, a Spartanburg Certified Public Accounting firm.  This column is intended to provide you with an informative summary of the subject matter covered.  You should consult with your tax and legal advisors for details and assistance in applying this general information to your specific situation. ( www.NormanJohnsonCPA.com)

 

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