A buy-sell agreement is a crucial legal document for any business with multiple owners. It outlines the process for transferring ownership shares in the event of a significant change, such as the death, disability, retirement or voluntary exit of a partner. While many businesses establish a buy-sell agreement early on, regularly reviewing it and updating it is equally important. We'll explore why ongoing reviews of buy-sell agreements are essential for the protection of business owners and the continuity of the business.
6 key reasons to review your buy-sell agreement regularly
1. Changes in business structure and ownership
Businesses aren't static; they evolve over time. Whether it's adding new partners, shareholders, or investors, these changes can significantly affect the dynamics of the business. When the ownership structure changes, the terms of the buy-sell agreement may need to be revised to account for new partners and their roles. Regular reviews allow business owners to ensure the agreement accurately reflects the current state of the business.
2. Adjusting for changes in valuation
The value of a business can fluctuate due to factors like market conditions, business performance or growth. Without regularly reviewing the buy-sell agreement to update the business's valuation, you risk having the agreement become outdated. If a buyout is triggered—whether due to death, disability, or voluntary departure—the terms of the agreement may lead to a price that's no longer fair or reflective of the business's true value. Regular updates help prevent this from happening.
3. Tax law and legal considerations
Tax laws and regulations change frequently. What was once a beneficial tax arrangement when the agreement was first drafted may no longer hold up under new tax laws. An outdated buy-sell agreement could lead to unexpected tax consequences for both the business and its owners when a buyout occurs. Regular reviews help keep the agreement compliant with current tax laws and can minimize potential tax burdens.
4. Addressing the possibility of disability or death
The unexpected death or disability of a business owner can create confusion and hardship for the remaining partners. Without clear provisions in the buy-sell agreement regarding these events, there's a risk of disputes between the deceased's family, the disabled partner and the remaining owners. Having provisions for the valuation of the business, funding mechanisms (such as life insurance) and buyout terms in place helps facilitate a smooth transition. Revisiting these terms periodically can keep them relevant and help address potential challenges.
5. Avoiding disputes and legal complications
One of the primary purposes of a buy-sell agreement is to prevent conflicts between business owners. Outdated or ambiguous terms can lead to disagreements, disputes, and even litigation when it's time to activate the buy-sell process. By reviewing the agreement regularly, you can identify potential points of conflict and address them before they become legal headaches. A well-drafted and up-to-date buy-sell agreement can make the process smoother, avoiding unnecessary complications.
6. Maintaining sufficient buyout financing
A crucial part of any buy-sell agreement is the mechanism for financing the buyout. Life insurance is often used to fund buyouts, but as business conditions change, so too can the amount of coverage required. If the value of the business has increased, or if the number of owners has changed, it's important to reassess whether the insurance policies or other funding mechanisms in place are sufficient. Regular reviews help ensure that there's adequate financing available for a smooth transaction when the time comes.
What the Connelly court ruling means for entity purchase agreements
In addition to general business and legal considerations, recent court decisions can also influence the structuring and review of buy-sell agreements. One such case that has had a significant impact is = Connelly v. United States. This decision highlighted the importance of carefully considering the structure of an entity's purchase agreement, especially regarding tax implications and the mechanics of ownership transfers.
In the Connelly case, the court ruled that certain provisions in an entity's purchase agreement, particularly those related to the allocation of purchase price and the timing of payments, could have unintended tax consequences. Specifically, the decision underscored the need for businesses to carefully structure their buy-sell agreements in a way that does not create excessive tax burdens or liabilities, particularly when it comes to the timing of buyout payments and how the payments are structured (e.g., installment payments versus lump-sum payments).
The ruling also emphasized the importance of making sure that the terms of the buy-sell agreement align with the goals of the business and its owners, particularly regarding tax efficiency. For example, businesses should make sure that their buy-sell agreements reflect an understanding of how tax laws impact the value of the business and how ownership interests are transferred, especially in light of recent changes in tax legislation.
How this affects entity purchase agreements:
- Tax Implications: The Connelly case serves as a reminder to review and update the buy-sell agreement to address potential tax consequences. This includes ensuring that the purchase price allocation, payment terms, and funding mechanisms are structured in a way that minimizes adverse tax implications for both the business and its owners.
- Funding Mechanisms: The decision also illustrates how critical it is to regularly review the financial mechanisms used to fund the buyout, such as life insurance or other forms of financing. Businesses should revisit these provisions to ensure they meet the evolving needs of the business and avoid triggering negative tax consequences.
- Clarification of Terms: After the Connelly decision, it is now even more critical to clarify key terms in the buy-sell agreement to avoid confusion or disputes during a triggering event. The agreement should clearly specify how purchase prices are determined, how payments are made, and the roles of all parties involved in the buyout process.
Best Practices for Reviewing a Buy-Sell Agreement
To keep your buy-sell agreement effective, consider these best practices for periodic reviews:
- Schedule regular reviews: Make reviewing the buy-sell agreement a regular part of your business planning process. Aim to revisit it at least once a year or whenever a significant change occurs, such as the addition of a new partner, a business acquisition or a significant shift in financial performance.
- Engage legal and financial professionals: Business owners should consult with legal and financial advisors to ensure the buy-sell agreement is compliant with current laws and effectively meets their needs. These professionals can provide guidance on potential legal or financial changes that might affect the agreement.
- Communicate with stakeholders: Regularly discuss the buy-sell agreement with all business partners or shareholders. It's important that everyone understands the terms and agrees on any updates, so there are no surprises when a triggering event occurs.
A buy-sell agreement is a vital tool for maintaining business continuity and protecting the interests of business owners. However, it's only effective if it remains up-to-date and relevant to the current state of the business. By regularly reviewing and updating the buy-sell agreement, you can help keep your business prepared for any changes that may arise, whether due to a partner's departure, changes in valuation, shifts in tax laws or court decisions like Connelly.
If you haven't already, now is the perfect time to schedule a review with your legal and financial advisors. Regular reviews can safeguard your business's future and provide peace of mind, knowing that you have a solid plan in place should the unexpected occur. Kaufman Rossin's experienced financial and insurance professionals can help assess your agreement and determine whether adjustments are needed to align with your business's evolving needs. Contact us to review your existing buy-sell agreement or explore options for establishing a new one.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
