Exit Planning Advisors that explain these common events to their clients and walk them through theoretical scenarios are more likely to get the owners motivated toreview their current buy-sell agreements.
The typical buy-sell agreement provision (if any) provides an option to the company to purchase an owner’s interest at the value agreed upon in the agreement. The form of payment is a multi-year promissory note. Depending on how valuation is determined in the agreement, the value may favor the buyer or the seller. Additionally, purchasing ownership in this manner creates a double tax on the income produced by the business.
So, what is the best approach to designing a buy-sell agreement to provide for the sale of an owner’s interest to other owners, the company, or key employees?
A good Exit Planning Advisor will bring in other specialists as needed. In this case, a specialist who understands the tax consequences of such a transaction to the buyer and the seller. The sale needs to be structured to minimize the tax consequences to the departing owner and to the buyer.
If an exit planning advisor is engaged early on, they will look to structure buyout scenarios before any co-owner is contemplating an exit and before any tensions build between the owners. The goal should be to agree on the total net after-tax proceeds a departing owner will receive, and then determine the most tax efficient way to accomplish that. The exit planning advisor and the tax specialist will address with the owners’ considerations such as:
- Method to establish value of company and value of a departing owner’s interest.
- Income tax minimization planning such as using the lowest defensible value and making up the difference via tax-deductible payments to the departing owner.
- Payment terms: cash or terms of promissory note plus… Incremental sale of ownership or wage continuation plan and other recommendations to transfer ownership on a tax- deductible basis.
In the specific case of the disability of a co-owner a recommendation would be to include in buy-sell agreements a disability buy-out provision that is funded with insurance. This is a simple, but partial solution to both the disabled owner and the company. It’s a partial solution because disability buy-out insurance seldom covers the entire value of the acquired ownership interest. The shortfall can be made up by installment payments between the company and the disabled owner.