Why business owners should consider buy-sell agreements before year-end
There is almost 32 million small businesses in the United States, according to the Small Business Association. Of these, 81% are one-person entities without employees. According to PNC, while 60 to 70% of small business owners want to handing over their business to the next generation, only 15% have a succession plan in place.
Having a succession plan in place protects the value you are building in your business so that you can have a more secure retirement, and also protects your family in the event of premature death. A succession plan also takes care of your customers.
With the tax changes coming, you may want to sell your business before the end of the year. If you want to put together a buy-sell agreement and get started selling your business before tax laws change and capital appreciation rates rise, this article provides you with a basic framework.
Why focus now on buy-sell agreements?
The U.S. Plan for Families presented by the Biden administration includes a proposal to increase the capital gains tax to 39.6% for the range from $ 1 million. However, the new proposition did not go far from this rate, the Ways and Means Committee having published a plan with a maximum rate of 25%, against 20% today. Additionally, if passed, this rate could begin for all capital gains transactions after September 13, 2021. While this does not affect most Americans, it could impact who sells their property. business. But even though there is no change in the law regarding capital gains, careful estate planning remains valuable today.
These potential changes could create an environment in which more business owners will want to sell their business before the end of the year. Maybe you are one of them.
Here is a brief overview of the main elements to take into account when entering into a buy-sell agreement:
- Who? Who is the right person to buy your business? Is it someone from inside? Are you considering an acquisition (acquisition of a company that will eventually take over)? Do you want to sell and leave the business?
- Cultural adjustment. Does the person looking to buy your business share the same business values (like adaptability, follow-through, etc.)?
- Legal structure. What type of buyback contract do you want to enter into? More information on this in the sections to come.
- Trigger event. What is the event that will trigger the buy-sell agreement? Is this a retirement, death, disability, divorce, term, termination of employment or voluntary sale?
- Funding. How will you finance the purchase when you leave the business? Are you going to use credit or cash? Life insurance?
In the sections to come, we will delve a little more specifically into the last three points.
Types and legal structures of buy-sell agreements
There are several types of buy-sell agreements, including:
Take the example of three business partners – Partners A, B and C – who enter into a cross buy-sell agreement. This means that they have equal property rights – one third each. If A dies – a trigger event – then B and C have agreed to buy equal parts of A’s stake, so B and C now own 50% of the partnership.
A cross buy works best with three or fewer owners. More than likely, the deal is structured such that homebuying owners receive a base raise. Additionally, if other owners receive life insurance benefits from the deceased owner, these are collected tax-free and do not increase the value of the business.
However, a cross-buy becomes more complicated if there are more than three owners. For example, A, B, and C in our original anecdote each get a life insurance policy on top of each other. But if there are more than three partners, the formula is (number of partners – 1) x number of partners. Therefore, if there are four partners, they would need 12 life insurance policies (3×4). If there are 10 partners, they would need 90 life insurance policies (9×10). It’s starting to get messy.
As the business grows, we might instead consider one of the following types of buy-sell contracts.
This means that the real entity will buy the share of the deceased or departing owner. Let us return to the example of the entity with three partners: if A dies, B and C will not obtain any new shares within the framework of a purchase-sale agreement of an entity. The entity itself buys the shares of A, and B and C still own a third each. But functionally, they still own the outstanding shares equally.
In this type of deal, the remaining owners are less likely to get a base increase, and the assets available to fund that purchase are now held at the company level, so any life insurance held there could be submitted to the company’s creditors. .
In some states, however, an entity itself cannot own assets, so be aware of your state’s rules.
Right of first refusal
This means that the seller can shop around for the business in third-party markets after the trigger event. The buyer having the right of first refusal has the possibility of making any offer correspond to his conditions or to more favorable conditions. The challenge here is that it is difficult to match the terms if the agreement is well drafted.
Right of first offer
This means that you have the right to buy before everyone else. Common language in this type of buy-sell agreement protects the buyer, and there is often a period during which they must make a decision.
Hybrid and other options
Forced buy-sell agreements occur when the triggering event triggers a structured sale. There is no right of refusal on either side.
You can also go the route of a purely time-limited purchase option. In this case, you will have to make the buy-sell agreement expire at some point, as there are perpetuity rules. For example, in a pure call option, you have the right to buy a business as long as a certain owner is still alive.
In any buy-sell agreement, you must take into account the triggering events. One of the biggest mistakes people make in buy-sell agreements is the wrong selection of trigger events. These include:
- Voluntary sale
- Bankruptcy of a shareholder or member
- Termination of employment (a distinction must be made with or without reason)
- Disability / incapacity
One of the best things about a buy-sell contract is that it allows us to define the financing and valuation of the business. For valuation, we will generally use a formula – usually EBITDA multiplied by an industry multiple. Sometimes companies will do an evaluation by an outside company. Valuation is an important part of a buy-sell agreement, as it will determine the price of the business and the financing the buyer will need.
There are several financing options.
Top-up sales could become more beneficial if capital gains taxes were increased to the proposed rates of 39.6% or even 25%. For example, if you are selling a business worth $ 5 million, you might want to structure the payments at $ 1 million per year for five years to avoid losing maybe 5-20% of the $ 4 million. of dollars subject to capital gains tax if you receive payment all at once. This type of planning would become even more important if the higher capital gains tax applied to all capital gains, even if your adjusted gross income exceeds the threshold of $ 1 million.
Above we talked about life insurance. You can take out a life insurance policy on key people in the entity. Full funding is guaranteed upfront and death benefits are exempt from income tax. This is usually the most economical approach, as the premiums are a fraction of the death benefit.
Sometimes, depending on the triggering event, you may need to borrow funds to complete a purchase if you are the buyer.
Businesses can be strengthened by having an appropriate buy-sell agreement in place. But often times people make mistakes in structuring them that cause problems.
Common mistakes include ignoring the tax implications of a sale, naming an inappropriate triggering event, failing to formalize the plan into a legally binding contract, and failing to update the plan as required. over time as the business evolves.
While it appears that a change to a maximum rate of 25% is more likely than 39.6%, both are only proposed rates at this point and any changes will need to be watched closely as the bills move forward. in Washington. However, if the current proposal passes, the date would already be set for September 13, 2021, so plan now!
Contact your financial services professional or lawyer for advice if you find yourself able to sell or buy a business in 2021 or beyond.