The importance of buy sell agreements – partnership agreements

Mary Rowland

In 1975, when two businesswomen in Kingston, Pa., bought a Tudor-style building to break into seven retail shops, they asked Delores M. Taren to run one of them. “They told me I could take my pick,” she recalls. She rejected selling books or stationary before agreeing on lingerie.

Two decades later, Taren and her founding partner, Wendy Anzalone, have not only expanded their store, Pillow Talk, and added a number of product lines, they have also dealt with a difficult business decision that many firms ignore or put off: They have drawn up a “will” for their company–in business terms, a buy/sell agreement.

The buy/sell agreement, which spells out what would happen to the firm if one of the partners were to leave the business, is important for their shop because in 1980 Anzalone developed multiple sclerosis, which created uncertainty about how long she could continue working.

It was Anzalone, then a 24-year-old former manager in a lingerie chain, whom Taren, then 42 and the wife of a plastics-factory owner, sought out as her partner after agreeing to run the lingerie store. In two decades, the store has grown to 3,600 square feet from 200, and today it features not only lingerie but also jewelry, lounge wear, and prostheses. “Business is booming,” says Taren, who is now divorced.

Although the disease’s progression has been slow and Anzalone remains active in the business, the two worked out a buy/sell agreement that specifies the terms of a buyout by either party in the event of death, disability, or retirement.

Lawyers and accountants say that all closely held businesses need such an agreement to determine how ownership would change hands and how the transfer would be paid for. Yet very few have buy/sell agreements. “It’s comparable to getting people to write their wills,” says Kenneth Wenzel, a Fort Worth, Texas, attorney who specializes in estate planning for small businesses. “Everyone knows they should have one. But everyone puts it off.”

Today, unlike the time when Taren and Anzalone set up shop, there are some pressures from outside to complete buy/sell agreements. Banks that make loans and companies that provide bonding for construction jobs often insist that small businesses have such agreements. “They say, `We’re relying on Joe and David to run this business,'” Wenzel says. “`If something happens to Joe, the company looks different to us. We don’t want to deal with the spouse or children.'” So a buy/sell agreement is often a precondition for bank financing or a bonding agreement.

A buy/sell agreement, which might cost about $2,500 to have an accountant or lawyer draft, should name the various events that would trigger a change of ownership. Most commonly, these include death, divorce, or retirement. The agreement should also specify who would have the right to buy the stock or partnership interest from a departing principal.

For example, the agreement might be triggered if one of the owners divorces and the judge awards part of the business to the former spouse. The agreement would stipulate that the other owners would have right to buy that interest back and would set the price for the buyback.

“The idea is to give the owners a right to keep the business among them,” says Michael V. Bourland Wenzel’s partner. “In order for it to hold up, all spouses must also sign the agreement when it is formulated.”

The agreement should also stipulate how the business would be valued. “When something happens, you don’t want to have to negotiate price or terms,” Bourland says. “You want it all laid out, so there is no dispute.”

The formula need not be complex, but it must be part of the signed agreement. For example, the partners or shareholders might agree to sit down each year and put a value on the business for the following year. If something happens to trigger the agreement during the year, that price would be used for the buyout.

Alternatively, the partners or shareholders might stipulate that the business will be appraised by three appraisers and that the middle figure will be used. Or they might simply agree that they will close the books and use a simple preset formula, such as the average of pretax income over the most recent three years multiplied by 8 or 10.

Another aspect that the agreement must address is financing for the buyout. If one owner is retiring, the money to buy out that owner can come out of cash generated by the business or from a cash-value life insurance policy set up for this purpose. If one owner dies, the proceeds from the policy, which is owned by the other owner or the business itself, would be used to buy the share of the business that had been owned by the deceased.

Taren and Anzalone’s agreement calls for a combination of the two approaches. Money from a cash-value policy would be used as a down payment, and the remainder would be paid off over time.

There are two basic ways to structure a buy/sell agreement, each with pros and cons. One method is a cross-purchase agreement, in which the remaining owners buy the departing owner’s stock or partnership interest. The advantage of this type of agreement is that the purchasers get a tax-saving “step-up” in basis to the market value of that portion of the business.

Consider this example. Suppose two partners put up $25,000 each to start a business that is now worth $2 million. One partner wants out. Under a cross-purchase agreement, the partner who buys that half share of the business takes $1 million as his basis for income-tax purposes rather than the $25,000.

With a cross-purchase arrangement, the owners typically buy life insurance policies on one another to finance the agreement. If there are just two owners, it’s pretty straightforward. “But if you have eight shareholders, that would mean buying dozens of policies,” Wenzel says. (See “Lowering Costs With First-To-Die,” October 1994.)

With the other type of agreement, called a stock-redemption agreement, the company buys the stock of the departing owner. In this scenario, the company would own the life insurance policy and pay the premiums. An advantage to this type of agreement is that if there are a number of owners, only one policy on each is necessary

There are some disadvantages, however, to a stock-redemption agreement. First, the company does-not get the same step-up in basis. In the example cited above, the company would pay $1 million for the half share, but it would carry a basis of only $25,000. If the business later were sold, capital-gains tax would be due on the amount over $25,000.

A second disadvantage is that if the life insurance to finance the redemption agreement is owned by a C corporation, the company may become liable for the alternative minimum tax (AMT) on any proceeds.

The AMT is not a problem for S corporations, though. “Today more and more people are set up in S corps,” Wenzel says. “They typically use redemption agreements because they like the idea of the corporation paying the premiums.” The premiums are not deductible to either the individual or the corporation, so the type of agreement–cross-purchase or stock-redemption–“makes little difference economically,” he says. Having a buy/sell agreement in place makes a great deal of difference, though, to guarantee the smooth transition of a business and ensure that it need not be sold at an inopportune time.

“The absence of an agreement can lead to chaos with different interests pulling the business in different directions,” says John D. Dadakis, an estates partner at Rogers & Wells, a New York law firm.

And an event that can threaten the stability of a partnership typically happens, he says, “when people are least prepared to deal with it.”

COPYRIGHT 1995 U.S. Chamber of Commerce

COPYRIGHT 2004 Gale Group

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