What Happens to Your Business When a Partner Dies?
Over the past nearly 20 years of advising the owners of small and mid-sized businesses on everything from valuations and exit strategies to guiding them through the final sale of their business, sadly we’ve encountered a couple of unfortunate examples of business owners being prepared for everything from downturns and competitive pressures to raw materials price spikes and all sorts of other business downsides – except for what is arguably the most important; when your business partner dies.
One of the most crucial considerations when establishing a business with multiple owners is to develop a buy-sell agreement, essentially providing a method for the remaining owners to carry on the business of the company without any more disruption than such a terrible event by itself normally entails and a way to make sure that no new, unwanted partners suddenly appear at the next board meeting.
When a business is owned by multiple individuals, the owners must, from the very beginning of the partnership, give consideration to the possibility that any number of disruptive events might happen that could throw the business into disarray. These include divorce, disability, disagreements, and, yes, death. There’s a good chance that one of these events will befall one of the partners. If the owners are not prepared for any of them, they are almost certainly in for a tough – and possibly catastrophic – time in the wake of any.
Over the past few weeks, we posted twice on the need to prepare for such eventualities. The first included an article by Owen Van Syckle, a financial services professional with New York Life, who wrote about how a buy/sell agreement can eliminate a lot of grief in the event of a partner’s disability. The second was a true story from my own experience where a client came to us to sell her half of a business because she was getting a divorce – and her husband also happened to be her business partner. Owen is a specialist on this topic and he has written an article on the issue of a partner’s death.
Owen’s article follows. If you have one or more partners in your business, pay attention. You’ll find Owen’s contact information at the end of this post.
A will directs the disposition of your assets; but when you do not want to leave your business to your heirs, you may also need a business purchase agreement (also known as a “buy-sell”) to outline the terms by which successor owners will acquire and continue the business.
A buy-sell agreement is most helpful:
• To create a “guaranteed” market for the sale of a business interest in the event of certain triggering events such as death, disability, retirement, divorce or bankruptcy, etc.
• If an owner would be unable or unwilling to continue running the business with the family of a departing owner
• Where the business involves a high amount of financial risk for a disabled or deceased owner’s family and it is preferable for the family to convert the business interest into cash.
• To prevent all or part of the business from falling into the hands of outsiders.
• To help establish the value of the business for federal and state estate tax purposes.
Participants of buy-sell agreements may include individual owners, the business, one or more trusts established by an individual owner, another entity owned by individual owners, family members or outside parties or a combination of these people and entities.
The most common types of buy-sell agreements are the cross-purchase plan (between the owners) and the entity purchase or – if the business is incorporated – stock redemption plan (between the owners and the business). The distinguishing feature is the party that agrees to buy the interests of the disabled, withdrawing or deceased owner.
In a cross-purchase plan, the individual owners themselves agree to buy the interest. In an entity purchase, the business itself buys (redeems) the departing owner’s interest.
A written agreement states the purchase price, terms, and funding arrangements. The agreement obligates the departing owner or owner’s estate to sell the business. Typically, either the business itself or the surviving owner(s) is obligated to buy the seller’s interests.
Occasionally, a “wait and see” agreement gives the remaining individual owners an option to buy the seller’s interests, but provides that, if the remaining owners fail to exercise the option, the business must buy them. The agreement specifies the events triggering the respective obligations and the sale price, or when and how the price is to be determined.
Generally, triggering events usually include the death, disability, bankruptcy, divorce or retirement of the owner. The sale price should be the fair market value, which can be determined by a formula or periodic appraisal. It can be paid in a lump sum, installment payments, or both. Often, the owners choose to pre-fund the agreement.
Usually, in a cross-purchase agreement, each owner/prospective buyer will buy, own, and be the beneficiary of life and disability income insurance on each other owner. In the case of an entity purchase agreement, the business buys, owns and is beneficiary of policies on each owner. Your attorney is in the best position to help you decide on the right agreement for you.
There are advantages and disadvantages to both types.
The advantages of a cross-purchase include that a surviving owner acquires interests with a stepped-up cost basis, which can reduce the tax impact if/when he/she sells. And if your business is a limited liability entity, policy values are generally not subject to company creditors.
Disadvantages include that when there are many owners who are parties to the agreement, more policies are needed to fund a cross-purchase than are needed for an entity purchase. For example, if there are four owners, each owner would own a policy on each of the other three owners, resulting in the need for twelve separate policies.
Also if the business is a corporation and a policy needs to be transferred (for example, due to a change in the ownership structure), a transfer for value occurs if the policy is transferred to a co-shareholder (other than the insured). That means a portion of the death benefit becomes subject to income tax.
Advantages of an entity purchase include that a minimal number of life insurance policies are needed. The business owns the policies and pays the premiums, which can minimize disputes as to the amount and payment of the costs to fund the agreement. Also, premiums paid by the business are not considered to be taxable income to the insured owner/ employee.
Disadvantages of this arrangement include that when family members are continuing in the business, attribution rules apply, which can result in the redemption being treated as a dividend to the estate, versus as a capital sale. Also, state laws may affect how and whether a corporation may buy its own shares.
When planning your business exit and succession, ask yourself a few questions: What did you find the last time you reviewed your buy-sell agreement? Is it designed properly to accomplish your goals and objectives? When is the last time you had the business appraised?
In the absence of a buy/sell agreement, if a partner dies, the remaining partners will be stuck with the deceased partner’s heirs as new partners. If your partner is married, has kids, grandkids or other heirs, you’d better like them – a lot – because they will be your new partners, whether they have enough sense to come in out of the rain or not. To assure that that doesn’t happen, you should have enough sense to implement a buy/sell agreement and to adequately fund it.
One of our clients is a nicely profitable service business started by four unrelated partners about four years ago. One of the partners was killed in a tragic accident about four years after the business started. That partner had a slew of heirs, none of which had any business sense and few of which even had any common sense. If, at the very beginning of the business, the partners had not included a buy/sell agreement as part of the corporate documents and funded that agreement with life insurance policies covering each of them, the heirs would have been spilling Big Gulps on the conference room table at the next board meeting. Fortunately, such an agreement – and the associated insurance – was in place describing exactly how the deceased partner’s share of the business would be valued and over what period of time the estate would be paid.
Unfortunately, many business owners never give these eventualities a thought and the damage – to the business, to the remaining owners and to the relationships among the owners and relatives of the deceased partner – is significant and sometimes irreparable. Buy-sell agreements between partners are a crucial component of any strategy to start, grow and sell a business. If your business has multiple owners but no buy-sell agreement, you’re running a huge risk. Something is going to happen to all of us; it’s just a matter of time.
If you’d like to learn more about how buy/sell agreements can help business owners, let me know in the Comments box below and I’ll send you a report done by Morgan Stanley on this topic. Don’t forget to include your email address.
If you like to contact Owen, you can reach him by email or by visiting his website – or just leave a comment in the Comment box below and we’ll get it to him. He intends to pen additional articles on this topic and we’re planning to post them to our blog as appropriate. So don’t forget to subscribe so you don’t miss what this expert has to say. It might save your business someday.
Finally, speaking of your business, what is the most pressing issue that you’re facing today? We’ve got a bunch of smart people here and we’d love to help. Let me know in the Comments box. If you leave your email, I’ll respond directly. If you don’t, perhaps a blog post or podcast will be a good place to answer it. So, let me know! If you’d prefer to reach me directly, you can do so at jo*@Wo*******************.com.
If you have any questions or comments, put them in the Comments box. I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!