October 27, 2010

Buy-Sell Agreement

If you are the co-owner of a small business with an unrelated individual then a buy-sell agreement is something you may have heard about. A buy-sell agreement is not exclusive to a certain business entity. It can be used for a corporation, general partnership, limited liability company, etc.

In short, a buy-sell agreement is a contract that facilitates an orderly transition of the ownership interests in the business on the occurrence of specified events, commonly death. For example, if husband owned a mechanic shop with another man, it is doubtful that wife would want to work there if husband were to pass away unexpectedly. Thus, a buy-sell agreement would be drafted to plan for such a situation.

Typically, each partner agrees to buy the other partner’s business interest when they pass away. This is known as a "cross-purchase."  A cross-purchase is usually ideal for both the decedent's heirs and the surviving business partner for the following reasons. In regards to the heirs, they are spared the trouble of operating a business they are probably disinterested in running. Instead, the heirs receive something of much greater value to them, a cash payment. Conversely, the surviving business partner is spared from having to work with the decedent's heirs, who lack business experience and acumen in that particular industry.

The most common way to fund a buy-sell agreement is through life insurance. Basically, each partner purchases a life insurance policy for the other partner and the purchasing partner is listed as the primary beneficiary of the other’s policy.

It sounds confusing but conceptually it makes sense once you think about it for a moment.

However, the purchasing partner is not permitted to run off with the life insurance proceeds and squander it in a Monte Carlo casino. Rather, the buy-sell agreement requires that the purchasing partner use the life insurance proceeds they receive to purchase the ownership interest from the deceased business person's heirs.

The following example should prove helpful in understanding the dynamics of a common buy-sell scenario.

Unrelated partners Able and Baker own a deli together as a general partnership. Able is married to Amie and Baker is married to Barbara. Able and Baker decide to draft a buy-sell agreement for a number of reasons. First, Amie and Barbara have said that they do not want to make sandwiches, serve customers during the lunch rush or handle tax matters should Able or Baker pass away unexpectedly. Second, even if Amie or Barbara change their minds about working at the deli, Able or Baker would rather not have to work with either of them because both lack the necessary experience and training to succeed in the food industry. Thus, Able and Baker retain the services of an attorney to draft a buy-sell agreement. The attorney instructs them to buy life insurance for each other and list the primary beneficiary as themselves. Lo and behold, Able passes away in a tragic car accident only months after drafting the buy-sell agreement and obtaining the associated life insurance. Baker receives the life insurance proceeds a short time later. Armed with the life insurance proceeds, Baker is able to purchase Able's interest in the business by giving the proceeds to Amie, the beneficiary of Able's estate. Thus, Amie receives what she wants, a cash payment and Baker receives what he wants, the ability to exclusively run the deli as he sees fit.