If you own an interest in a family-owned or other closely held business, a buy-sell agreement is a valuable document to have in place. These agreements specify whether — and under what circumstances — owners’ interests may be transferred. These should be planned and drafted carefully to ensure they meet your expectations without triggering unwanted tax consequences or conflicts with other owners or family members.
A well-crafted buy-sell agreement provides many benefits, including:
Typically, buy-sell agreements achieve these objectives by requiring or permitting the company (or the remaining owners) to purchase the interest of an owner who dies, becomes disabled, or leaves the business. They may also provide the company (or the remaining owners) with a right of first refusal in the event an owner wishes to sell his/her interest.
Generally, buy-sell agreements are structured either as “redemption” agreements or “cross-purchase” agreements.
From a tax perspective, cross-purchase agreements are generally preferable. The remaining owners receive the equivalent of a “stepped-up basis” in the purchased shares, in that their basis for those shares will be determined by the price paid, which is the current fair market value. Having a higher basis will reduce their capital gains if they sell their interests down the road. Also, if the remaining owners fund the purchase with life insurance, the insurance proceeds are generally tax-free.
The disadvantage of a cross-purchase agreement is that the owners, rather than the company, are responsible for funding the purchase of a departing owner’s interest. If they use life insurance as a funding source, each owner will need to maintain insurance policies for the life of each of the other shareholders, which is a potentially cumbersome and expensive arrangement.
Redemption agreements, on the other hand, may trigger a variety of unwanted tax consequences.
A buy-sell agreement’s valuation provision is critical to avoiding unpleasant surprises or conflicts. Generally, the fairest and most effective method of setting the purchase price is to conduct periodic independent business valuations and to base the price on fair market value.
Many agreements set the price using a formula tied to earnings, cash flow, book value, or some other objective measure. Although formulas offer simplicity and lower costs, they can’t account for subjective characteristics or other factors that drive business value. As a result, they often underestimate or overestimate business value, which can lead to disputes when the buy-sell agreement is invoked.
The terms “buy-sell agreement” and “shareholders’ agreement” are often used interchangeably. But in fact, a shareholders’ agreement refers to a broader category of which a buy-sell agreement is a subset.
Before signing a buy-sell agreement, test it to see how it’ll perform under various scenarios and choose your words carefully to ensure it fulfills all your objectives. Consult your tax advisor and your attorney for assistance.
Our team of experts at Froehling Anderson is here to help you!
Contact us today, and let us help you understand the advantages and tax implications of a buy-sell agreement.
Originally published on February 2022. Updated April 2025 for freshness and accuracy.
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