If you are a business owner, then chances are you have heard of a buy-sell agreement. What most people don’t understand is what it really is, or why it is important. Simply put, they are exit strategies for business owners. To fully understand what it is, you must know what they entail.
What Is It
A business buy-sell agreement, also known as a buyout agreement, is a legally binding contract between the owners or partners of a business. It outlines the terms and conditions for buying or selling an ownership interest in the company. The contract usually provides detailed information about how to deal with certain situations. This could be various events, such as death, disability, divorce, retirement, or voluntary exit of an owner.
Why Is It Important?
One major situation where they are important is during ownership transition. A buy sell agreement ensures a smooth transition when an owner decides to leave the business or is forced to exit due to unforeseen circumstances. It outlines the process, price, and terms under which the ownership interest can be bought or sold. Another thing this contract includes is a value for the business owners’ share. This is important because it can help avoid conflicts about the fair value of the business.
One thing that can impact a buy or sell agreement is where the funding comes from in the case of a buyout. Since a business often doesn’t have the excess cash to buy out one of its owners, they use life insurance as a funding vehicle. This is where the type of business you have matters. Who owns this policy depends on the type of corporation you have, S-Corp, C-Corp, LLC, Partnership, or Sole proprietorship. Setting this up incorrectly can lead to tax problems or step up in basis issues.
A well thought out buy-sell agreement will include what steps to follow if one of the business owners decides to retire. A retiring shareholder can decide to sell their interest through this process. In this event the shares are usually bought by the other owners of the corporation.
Different Types of Agreements
There are three different types of buy-sell agreements. Cross Purchase Agreement is the first. This type of Agreement enables a firm’s owners or other owners to buy the shares at a certain price. This typically happens after death or disability. Another type of agreement is a Redemption Agreement. A Redemption Agreement is when the company itself is obligated to purchase the shares of a deceased or existing owner. The final type of agreement is a Hybrid agreement. Just like its name suggests, it is a combination of the two. In this type of agreement, both business and the remaining owners can buy the interest of the existing or deceased owner at a pre-determined price.
Overall, a buy-sell agreement serves as a crucial tool for protecting the interests of business owners, ensuring a smooth ownership transition, maintaining business continuity, and establishing a fair and agreed-upon process for buying or selling ownership interests in the company. Consulting with a legal professional is very important in this process. If you have any more question about the tax implications that these agreements hold, then reach out to us below. Or to read more about a Buy-Sell agreement, click the link below.