In the context of executors and trustees whom we represent in the administration of an estate following the death of a loved one, we often see a lack of planning regarding the disposition of a business owner’s share in a privately held company prior to their death. This lack of planning unfortunately typically requires the surviving family, as well as the other business owners involved, to incur unnecessary legal costs and expenses to ensure the proper disposition and sale of the individual business owner’s share. This is often also coupled with possible liquidity and business continuity issues for the company.
In many instances, a formal business valuation of the company is required in order to adequately value the interest of the deceased business owner for estate administration purposes. Further, following the valuation of the deceased business owner’s interest, the purchase of the deceased business owner’s share from their estate or trust may be equally difficult due to the unavailability of liquid funds. The failure to plan ahead can sadly cause significant financial uncertainty for both the surviving family and the company as a whole, which is why a buy-sell agreement is such a critical planning mechanism.
Generally, a buy-sell agreement is a contractual agreement between co-owners of a business which governs what will happen to the ownership of the business in the event of a co-owner’s death or other event that causes a co-owner to leave the business, either voluntarily or involuntarily.
Although the death of a business owner is often the most common reason one may think of in the context of succession planning, there are a host of other reasons why a privately held company needs to engage in succession planning. Some of these other possibilities include an owner:
- being forced out of the business or otherwise terminated,
- retiring,
- suffering a permanent disability in which he or she is unable to return to work full-time,
- going through a divorce in which the business interest is considered marital property, and
- filing for personal bankruptcy.
The concerns outlined above can bring about a multitude of business succession issues which, without the proper planning, could result in business continuity issues for the company. For instance, the remaining business owners could find themselves partnered with new owners with whom they would not otherwise want to share and operate their business. They may face liquidity issues in purchasing a departing owner’s share in the business, and/or there may be no concrete mechanisms and terms in place for the purchase of the share of the departing co-owner of the company.
Therefore, special consideration should be paid to the terms and provisions to include in a buy-sell agreement. Some of the terms and provisions that a business may want to consider include:
- the conditions which will trigger a mandatory buy-out, e.g., death of an owner, disability of an owner, divorce of an owner, etc.,
- the purchase and sale structure which will be followed upon the triggering of a buy-out condition,
- the valuation of the company and what conditions will require future valuations of the company,
- what source(s) of funding will be utilized to buy out the departing business owner, e.g., insurance proceeds, promissory note, etc., and
- what are the anticipated tax considerations of the buy-out.
Each one of these considerations should be discussed among the business owners and their respective counsel in order to ensure a proper and orderly transition of the business from one business owner to the next upon the occurrence of each possible condition. For instance, will the buy-out of an owner’s share be funded with life insurance purchased by the company, or will the buy-out be funded through a down payment followed by a promissory note in which the company pays out the departing owner, or his or her estate, as the case may be, over a certain number of years?
Further, tax considerations should always be a part of every succession planning discussion. The failure to consider tax consequences of a disposition of the owner’s interest in the business could result in tax consequences for the company. By way of example, a business which is recognized as an S corporation would want to avoid the possibility of any action which could jeopardize the company’s S corporation status following the disposition of an owner’s share.
This impacts the final consideration we will highlight in this article, that being the individual estate planning considerations of each owner of the business. Each owner will want to review their existing estate plan to ensure their plan will work in conjunction with the succession plan of the business. A particularly important point is to ensure that an owner’s trust would be able to be considered an eligible shareholder under the Internal Revenue Code so as to avoid any inadvertent violations of the S corporation rules that could jeopardize the company’s S corporation status.
A privately held company should routinely review and address changes in its succession plan so as to ensure liquidity to fund its current succession plan, business continuity, and avoidance of unnecessary tax consequences.
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