February 2004
By JAMES S. ANCHIN, CPA
If your business partner decided tomorrow that he wanted to leave the business and sell his interest, what are the implications for you and your company? Can you or the other remaining owners snatch up his interest at a bargain price? Is a funding mechanism in place to buy out your partner? Could your partner sell his interest to an outside party without your consent? What happens if your partner should suddenly become disabled or pass away? The tax ramifications of any of these actions must also be considered.
These and other questions should be addressed in a properly structured buy-sell agreement.
Today, a must-have for contracting companies with multiple owners is a solid, well-planned, buy-sell agreement that prevents unrestricted transfer of ownership interests and stipulates the next step when one of the owners dies, becomes disabled, retires or otherwise withdraws from business.
Buy-sell agreements should cover all the bases and specify the conditions for each type of withdrawal from the company. If one partner becomes disabled, how long can they remain before being required to give up ownership interests in the company? And how exactly is "disabled" defined? These fine points should be spelled out in the agreement.
The agreement should limit an owner's ability to sell their interest to an outside party. The remaining owner(s) of the company should have the right of first refusal to buy the interest of the departing owner.
People have various ideas about the right age to retire, and a good buy-sell agreement will also state the minimum retirement ageÑpartners seeking to sell their ownership interests before that age would fall under the voluntary withdrawal category and be subject to different requirements. When it comes to voluntary withdrawals, the agreement must state how much notice the terminating owner must give and whether there will be a penalty if that owner immediately or eventually joins the competition Ð either by forming a new company or working for an existing one. Critical to the future well being of the company, the logistics of voting in a new partner should be carefully hammered out and contained in the agreement.
What is a fair buy-out price? Long before any money changes hands, that subject should be scrutinized from every angle and reviewed and agreed upon by all interested parties and their spouses. A formula must be established to calculate the buy-out price. If the buy-out price is established by appraised value, all co-owners should put their stamp of approval on the appraiser.
Contractors should also pre-determine how the buy-out price will be paid and be aware of the tax consequences of the buy-out. One way to fund buy-outs is through life insurance policies, one for A and one for B.
A better way to go may be to buy one first-to-die policy, covering both owners, at a lower premium cost, that pays upon the death of the first owner to die. Alternatively, an owner can be bought out through a redemption by the company. Which method is preferable depends on the facts and circumstances in each case. Different tax consequences result depending on the legal structure of the company such as a C corp., S corp., LLC, or partnership.
Of course, the ideal time to draft a buy-sell agreement is when the company is launched. But, if you don't already have such an agreement in place, start now before you really need one. There's rarely a ready market for closely held businesses, and buy-sell agreements create a captive market. Plus, individuals with ownership interest are more likely to strike a fair buy-out price when there is no sellout proposition on the table-and who knows which owner will be the first to invoke the buy-sell agreement.
A sound buy-sell agreement may also make a contractor a more attractive candidate to banks and bonding companies; the last thing lenders want is to have to take over a company in turmoil or one plagued with uncertainties about ownership. Contractors will find it's well worth the time and effort to work up a buy-sell agreement, because it eliminates problems down the line and it forces the company to do the still necessary estate planning that may otherwise go by the boards.
About the author: Mr.
Anchin is a managing partner of Anchin, Block & Anchin, LLP, a regional
certified public accounting firm with offices in New York City and Westchester,
that specializes in meeting the needs of contractors in the tri-state area.