What Is a Buy Sell Agreement?

A buy sell is a contract between business owners that establishes the terms for a smooth transition of ownership in the event of a triggering event. It can be used by businesses structured as a partnership or a closed corporation, or even by a statutory trust (for S corporations). Consultation with legal and financial professionals experienced in business succession planning and brokers experienced in buy-sell insurance is recommended.

A triggering event can be the death of an owner, disability, bankruptcy, divorce, retirement, insolvency or termination of employment. These agreements can also be designed to permit a purchase by the business, an outsider or a family member of the deceased owner. These agreements can also be triggered by the occurrence of an insolvency event, such as the liquidation of the business or insolvency due to unpaid taxes.

The main purpose of this agreement is to set the price at which a departing owner’s share will be bought out. Ideally, the price is determined at the time the contract is drawn up. However, it may not be possible to determine a value for the shares at that time, so most agreements use an automatic or trigger event-based method for determining the purchase price. This method of valuing a business is commonly known as fair market value, or FMV. The IRS typically accepts this valuation as the taxable amount if certain conditions are met.

In addition to the price, a buy-sell agreement will specify who can purchase an interest in the business when the triggering event occurs. It can be very difficult to manage a business when a partner or co-owner suddenly dies without this type of contract in place. Without one, the deceased’s estate may be forced to sell their share of the business at an unfairly low price to a competitor or someone else with no knowledge of the day-to-day operations of the business.

Most agreements are funded by life insurance policies on the lives of each of the co-owners. These policies can be owned by the partners, by the individual shareholders, or by a trust or limited liability company for tax-related reasons.

Although the purchase and sale of ownership interests is a serious matter, many businesses overlook the importance of this agreement. It should be reviewed on a regular basis to ensure that the terms are still in effect and that they remain enforceable. A well-drafted buy-sell will help prevent disputes and costly litigation should the unexpected happen to your business. This is a good reason for all owners to work together to implement this critical agreement. It will pay dividends in the long run for everyone.