Many businesses that are owned and managed by multiple partners or family members do not have a plan in place should certain triggering events occur such as death or divorce. It is important to have a contingency plan to ensure a smooth transition at little or no expense to the existing owners.
What is a buy and sell agreement?
Think of it similar to a Will, but for a business. Essentially, it is a binding agreement between the owners or principals of the business (no matter the entity type) that determines what will happen in the event that a partner passes way, is held up in a divorce, files for bankruptcy or leaves the firm.
Many buy and sell agreements contain an insurance component which guarantees that in the event a partner is no longer with us, the other partner(s) will have the cash value to purchase the other share of the business. The clauses in the buy and sell agreements will dictate the outcome. This is why it is particularly important for all parties involved to pay close attention to every detail in the agreement.
What are the different types of agreements?
There are generally three types of buy and sell agreements. The entity redemption arrangement, which sounds exactly like it is, it allows the actual entity to purchase the deceased or exiting owner’s share. This plan can have many disadvantages such as the risk of being subject to the alternative minimum tax if the entity is a C Corp and restrictions regarding the the value of the insurance proceeds, among other factors. Needless to say, the redemption arrangement is probably not the best choice.
The cross-hair arrangement, on the other hand, allows the co-owners to purchase the exiting or deceased owner’s share with the tax-free cash value provided in the insurance policy. The problem with this plan is that the cost to acquire the necessary insurance to cover many owners can become very expensive. So, you’re probably wondering if there is an option that contains the most attractive components of both arrangements? There is, it’s called the mixed arrangement which provides the entity and its owners with great flexibility when a triggering event occurs. Basically, the entity or the owners have the option to purchase the shares depending on which is most beneficial for all parties involved.
What if I don’t know what the future will hold for the business?
It may seem foolish to detail the terms and conditions of future events when you’re not sure what will happen to your business. However, it is much better to have one in place than not because you will avoid the legal battles later on which are out of your control and can be very expensive.
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