Buy-Sell Agreements for Family Businesses

Overview

The needs and capabilities of a farming or ranching business (or any business for that matter) need to be integrated with business and estate plans, and the retirement needs, of each of the owners. A buy-sell agreement is a frequently used mechanism for dealing with these issues.  For many small businesses, a well-drafted buy-sell agreement is perhaps just as important as a will or trust.  It can be the key to passing on the business to the next generation successfully.  For most farming and ranching operations, succession planning is now more important than estate tax planning.  That makes a good buy-sell agreement an important document. 

Buy-sell agreements – the basics of what they are and how they work, that’s the topic of today’s post.

General

A buy-sell agreement is typically a separate document, although some (or all) of its provisions may be incorporated in its bylaws, the partnership agreement, the LLC operating agreement and, on occasion, in an employment agreement with owner-employees.  Major reasons for having a buy-sell agreement include:  establishing continuity of business ownership; providing a market for otherwise illiquid closely held shares; establishing a funding source and a mechanism for share purchase; establishing certainty as to the value of the shares for estate purposes; and providing restrictions on operational matters, e.g. voting control and protection of S corporation status.

Establishment of Estate Tax Value

While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are.  For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.

There are six basic requirements for a buy-sell agreement to establish value of a deceased owner’s interest:  (1) the interest must be subject to an option to purchase that is a binding obligation on the estate; (2) the purchase price must be established with certainty; (3) the interest must not be subject to lifetime transfers that could defeat the obligation to purchase; (4) there must be a “ bona fide business arrangement”; (5) the agreement cannot be a device to transfer at lower than fair market value; and (5) the agreement must be comparable to similar arrangements between persons in an arms-length transaction.

The estate must be obligated to sell; however, there is no requirement for the purchaser to buy. However, there is often an additional provision in such agreements to provide that if adequate funding is available, the survivors are obligated to purchase in order to provide estate liquidity, and often to protect the deceased shareholder’s family from the vagaries of the ongoing business.

To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of § 2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.

A key point is that, to be effective in establishing a value for estate tax purposes, the buy-sell agreement must provide that the corporation or shareholders are either obligated or have an option to purchase the shares of a holder who desires to sell within his lifetime, at the same price and on the same terms as provided for upon the death of the shareholder. A right of first refusal will not accomplish the same objective and will potentially contravene the requirements of I.R.C. §2031. From the selling shareholder’s viewpoint, either an option or right of first refusal may not be acceptable because of their failure to guarantee a market for the shares. 

The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth”.  Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167(2001), aff’d 390 F. 3d 1210 (2004), and Estate of Blount v. Comr., T.C. Memo 2004-116(2004).

Valuation methods.  There are several general valuation methods for buy-sell agreements. 

One method is the fixed value method.  Under this method, the value of the interest being valued doesn’t change.  It is not used much, and would not meet most IRS requirements under IRC §2703(b) and the regulations.

Another approach is one that uses an appraisal to value the underlying business interest.  This method is also rarely used for operating businesses, but may be appropriate for certain types of business such as real estate. If this method is used it is often a triple appraisal approach, where the purchaser and estate each appoint an appraiser who appoints a third if the first two cannot agree. A drawback is that the valuation is left until the triggering event (death, disability, etc.), leaving the owners with little guidance for the necessary funding decisions.

The formula method uses book value from the financial statements of the business to value the interest.  That is relatively easy to determine, but it will result in a significant deviation from fair market value unless adjusted for such matters as the company’s accounting method, differences between book and fair market value for real estate, equipment, other tangible assets and intangible assets. Other adjustments may include accounts receivable to reflect collectability, and an examination of the adequacy of reserve accounts.

Another formula method is one based on earnings which are then capitalized to arrive at a proper value. The selection of an appropriate capitalization rate is an important determination, and it must be recognized that a rate appropriate at the time of the agreement may not be appropriate later due to a change in business or the economic environment.

Agreed value is another frequently used method of valuation, usually combined with periodic adjustments by the parties. This is often coupled with a back-up valuation method to take effect within a certain period of time if a value has not been adopted.

Another commonly used provision is one that requires any outside purchaser of the business to adopt the buy-sell agreement. In the case of a limited liability company, the requirement may be to adopt the operating agreement before becoming a member. Either of these provisions serves to protect the remaining owners.

Who Will Be the Buyer?

When setting up a buy-sell agreement for your farm/ranch (or other) business, an important decision at the beginning is to determine who will be the purchaser.  Not only is establishing a purchase price important, but determining how the purchase price will be paid is also important.  This is a function of the type of buy-sell agreement that is utilized.  With a “redemption’ type agreement, the corporation is the buyer.  With a “cross-purchase” agreement, the other shareholders are the buyers.  A buy-sell agreement can also be a combination of a redemption and cross-purchase agreement. 

Since life insurance on the lives of the shareholders is often used to partially or fully fund a buy-sell agreement, the availability and affordability of insurance, the number of policies needed, and the source of funds to pay the premiums will often dictate the type of agreement selected.  The amount will depend upon the valuation of the company, the limits on corporate or shareholder finances to pay the premiums, and the extent to which both the shareholders and the seller are willing to assume an unfunded liability if the buy-sell is not fully funded by insurance.  Multiple policies may be required for a cross-purchase agreement unless a partnership can be utilized to hold the insurance (e.g. if three shareholders, there would be six separate policies; if four shareholders, twelve policies) so that beyond a few shareholders may make this approach impractical. However, a single policy on each shareholder would suffice when funding a corporate redemption. Another possible solution is a buy-out insurance trust which owns the policies. 

If the farming business owns the policy, the business can borrow against any cash value if needed.  If no trust or partnership is used, a cross-purchase agreement leaves the payment of premiums in the control of the individual shareholder, and potentially subjects any cash value to creditor claims. This factor alone may determine which form of agreement is most desirable.

If there is a disparity in ownership shares (and there often is), a minority shareholder may be required to fund the much higher interest of the majority shareholder(s) in a cross-purchase agreement. In a corporate redemption, however, the funding of the purchase, either from insurance or other corporate assets, is being born by the shareholders in proportion to their relative stock interests.

While life insurance will often solve the funding problem for purchasing a deceased shareholders stock, and disability insurance is available for permanent disability, insurance proceeds are generally not available in lifetime purchase situations. Thus, the funding capability of the parties is critical since there may not be an alternative funding method available that will satisfy all parties. However, in many situations non-insurance methods of funding coupled with installment payments of the purchase price will meet most of the major needs of the parties.

Conclusion

Today’s post was only a surface-level discussion on buy sell agreements.  A good buy-sell agreement is an essential part of transitioning a business to the next generation of owners.  But, it is complex and a great deal of thought must be given to the proper crafting of the agreement.  Of course, there are associated tax considerations which were not covered in this post.  In addition, there are numerous financial and personal factors that also come into play.  Likewise, significant thought must be given to the events that can trigger the operation of the agreement. 

Like other estate planning documents, a buy-sell agreement should be reviewed regularly even in the absence of any potentially triggering event, and particularly when there is any change in the business structure or ownership.