For Partners, Buy-Sell Agreements Can Bring Peace of Mind
Jim Jordan is director of construction services for Dallas/Fort Worth-based Weaver and Tidwell LLP.
Business conditions and relationships can change quickly, so make sure your agreement reflects current realities and personal plans.
Most contracting firms are privately held entities, and a sizeable number operate as partnerships. In such a business model, one of the biggest risks is that the owners or partners do not have a buy-sell agreement. It’s not an uncommon omission. Somewhere in the hustle and bustle of maturing their construction operation, partners never got around to discussing how their business would operate if one of them unexpectedly died.
It’s a dangerous situation. In the absence of a formal buy-sell agreement, the death of a partner, a divorce, or even the desire by one partner to leave the business, can force a liquidation of the company or a sale to outsiders. However, all this stress as well as unexpected tax liabilities can be averted by a simple buy-sell agreement.
Despite popular belief, a buy-sell agreement is not about buying and selling a company, but rather is a binding contract between partners spelling out the future ownership of their contracting business. Actually, it’s sort of a pre-nuptial agreement, and it’s best to draw it up when the business is new and all partners have common goals. Moreover, the agreement needs to be reviewed every two to three years to make certain the original terms and conditions remain relevant. The document should continue to clearly delineate “triggering’’ events and include a funding mechanism that allows the company to fulfill its contractual obligations without inviting financial ruin.
If drafted properly, a buy-sell agreement will:
• Establish that an owner’s interest must be sold to the company, the remaining owners, or a combination of the two.
• Establish that once a triggering event occurs, owners are guaranteed that their interest in the business will be purchased.
• Establish the methodology of computing the purchase and sales price of the ownership interest.
• Provide a funding source and payment terms that will allow the company to maintain its financial viability.
• Determine the value of a deceased owner’s interest in the business for estate tax purposes.
When drafting their agreement, partners first need to establish trigger events. Obviously the first trigger is death or disability. Others may be retirement, a divorce settlement that passes ownership to a spouse, personal bankruptcy of a partner, foreclosure of a debt secured by the partners, termination or an offer from an outside buyer to purchase one partner’s interest.
Triggers might also include the simple desire to opt out of the business. Sometimes partners no longer get along and want to severe their ties. This situation can be addressed in buy-sell agreements with “Russian roulette,’’ “slice-of-the-pie’’ or “shoot-out’’ clauses. These clauses allow one partner to buy out the other, but both owners have to have equal financial resources and own a similar percentage of the business.
At its core, a buy-sell agreement is intended to prevent stockholders, partners and/or members (in the case of a limited liability company) from transferring their ownership interest to outsiders. Usually there is an exception that allows an owner to transfer his or her ownership interests as gifts to certain family members, provided approval is first obtained by the remaining owners.
If a business buys back the ownership interest, it is called redemption. If the other owners buy the interest, it is called a cross-purchase. Usually there is more favorable tax treatment for the seller if he or she sells to other owners instead of the business itself. Some states restrict a corporation from purchasing its own shares under certain situations. There usually is no such limitation on the ability of other shareholders or owners to purchase a co-owner’s interest. Often it is wise for owners to use a hybrid method or adopt a wait-and-see arrangement. In this case, the buy-sell agreement would state that the company has the first option to buy the interest of the selling owner, and if the company doesn’t acquire the interest, the other owners have the right to purchase the interests.
It’s important to remember that in order for a buy-sell agreement to establish a value for federal estate tax purposes, it must have restrictions on the transfer of ownership. For example, the agreement might state that an owner can buy his partner’s share only when that partner retires.
Of course, no purchase of ownership can occur easily if the business hasn’t been properly valued. A buy-sell agreement doesn’t have to establish a company’s value, but it should clearly state how that value is to be determined, which usually is through audited financial statements. Contractors then can use various methods to arrive at a value, including capitalization of earnings, discounted cash flow and book value. Because the process can be complex, it’s essential to get help from a certified public accountant who specializes in construction.
A buy-sell agreement also must address funding of the purchase obligation and the payment terms. Generally owners of construction companies have devoted years to making the business successful. While they want to receive full payment for their efforts, they also want the company to continue to the next generation. The central issue then becomes the source of funds for the purchase of their interests. Many agreements have provisions for key life insurance to be purchased by the company on the owners. The company uses the proceeds to purchase the seller’s interest.
In addition, there are “first-to-die’’ policies that pay a death benefit to whichever partner survives the other. When a company has more than two owners, however, partners may need to be more creative. Some contracting firms with three or more partners set up a type of round-robin insurance plan that works this way: Let’s say there are three partners, Ted, Carol and Alice. Ted buys life insurance policies on Carol and Alice. Carol buys policies on Ted and Alice. And Alice buys policies on Ted and Carol. When one of the partners dies, the other two receive death benefits, providing the funds necessary to purchase the deceased partner’s share of ownership. There are many ways life insurance can be used to provide the necessary cash to fund the purchase obligation.
When retirement or illness is a more pressing concern than premature death, life insurance is still a good idea: The policy can be structured so a cash payout (percentage of the face amount) is available at any time.