The Many Purposes of a Buy-Sell Agreement

Before starting the complex process of designing a buy-sell agreement, the shareholders of a closely-held corporation (or the members of a limited liability company or the partners of a partnership) should clearly define in their own minds the purposes for their entering into this process.  Unless a clear set of goals is understood by all at the outset, the successful completion of an agreement could be wrecked by avoidance-motivated disagreement over its terms resulting in interminable delays.

The Goals of a Buy-Sell Agreement.  A buy-sell agreement can have one of two purposes: First, it can restrict the transfer of shares during the lifetime of the shareholders.  The result of such an agreement is that the shares of a company remain within the original group of shareholders, and possibly their close family members.  While at first glance, this seems to be a positive result, it may not be in the long run.  The estate’s ownership of shares in a closely-held corporation threatens the company with the danger of interference in the running of the business by an executor unwilling or unable to manage a going business.  If the shares wind up in the hands of a spouse or children totally unfamiliar with the operation of the business, this often sets up a conflict of opposing interests that can threaten the survival of a company.  It’s not a pretty sight.

The second goal of a buy-sell agreement is to establish the value of shares for estate tax purposes.  Establishing the value of shares is an important goal, because the value of shares is often disputed by the IRS and is one issue that frequently results in intense, prolonged and costly litigation.  The IRS often takes the position that the shares of a deceased owner are worth more than the value reported by the estate on its estate tax return.  In the worst scenario, the IRS succeeds in challenging the reported value, the estate must sell the shares to the corporation or to the surviving shareholders at the lower contract value and pay the estate tax for the higher value.

Obviously, that’s not the idea in entering into a buy-sell agreement.  So, one principal objective of drafting a buy-sell agreement is to provide the methodology for fixing the value of the shares that will have the greatest probability of binding the IRS to the value fixed in the agreement.  This requires great care to understand the nature of the business and to provide a formula and a process that accomplish the goals of the shareholders.  

What won’t work:  No one price formula will fit all situations.  A price arrived at when a shareholder was ill might not be respected.  A parent dictating the terms of an agreement with his or her family probably won’t be binding on the IRS, although it may be binding on the shareholders.  A fixed price that is not modified over time will not be effective to bind the IRS.  Fixing a price and paying for the deceased shareholder’s interest with a fixed face value life insurance policy won’t work.  The exclusion of certain assets, such as goodwill, from the formula probably won’t work, either.  

What will work: As you can guess, every situation is different and no one factor will be determinative for all cases.  But, as a matter of common sense, these characteristics of a buy-sell agreement will help to accomplish its purposes:

•        The agreement must not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration.   To meet this requirement, two requirements must be satisfied: First, the buy-sell agreement must not be designed to serve a “testamentary purpose.”  Second, the formula for establishing the purchase price of interests subject to a buy-sell agreement must be fair.

•        The agreement must have terms comparable to those of similar arrangements entered into by persons in an arm’s-length transaction.  

•        The agreement must provide the value or mechanism for establishing the value of the stock.

•        The estate of the deceased shareholder must be obligated to sell the shares on the decedent’s death.

•        The decedent cannot be free to dispose of the stock at any price he chooses during his lifetime.  At a minimum, this requires a “right of first refusal” in the agreement at a price no greater that the price set for sale at the death of the shareholder.

What is clear is that a buy-sell agreement is critical to preserving the value of a business interest and maximizing the greatest portion of that value for one’s family.  What’s more, it cannot be entered into lightly or without proper professional guidance and assistance.

In future articles, we will discuss other goals of a buy-sell agreement, integrating a buy-sell agreement with other estate planning strategies, alternative types of agreements and other considerations that go into a well-designed succession plan.

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Last modified: December 27, 2007

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