Every business or professional relationship you have today or will ever have will eventually end. Businesses fail. Partners move on to other interests. A business partner might become ill or even pass away. Other businesses are sold or merge into bigger companies. It is inevitable that business partnerships end. Thus, it only makes sense to plan for the end of your business relationship with a partner or partners. That’s what a buy-sell agreement can accomplish.
The Big D’s- Triggering Events
A good buy-sell agreement will contain a list of events or conditions that trigger a right or obligation for one business partner to buy the interests of another partner. Those triggering events usually include one or all of the following:
- Death- What happens if an owner dies?
- Disability- What happens if an active owner can longer contribute?
- Disinterest- What happens if an owner wants out of the business?
- Dishonesty- What happens if an owner cheats the company?
- Divorce- Can an owner’s spouse get her ownership in a divorce?
What happens after a Triggering Event?
Once an event triggers, one business partner has an option or an obligation to buy another partner’s ownership. For example, if Bill becomes permanently disabled and can longer contribute to the company’s success, his partner, Carol, would have the right or obligation to buy Bill’s interests. Or, if Carol gets a divorce, Bill probably does not want Carol’s ex-husband to become Bill’s business partner. These and the other Big D’s can be addressed in a good Buy-Sell Agreement.
Who sets the terms of a Buy-Sell Agreement?
Buy-Sell Agreements are negotiated and agreed to by the owners of the company. It is always best to resolve buy-sell agreements early, before any of the owners know whether he or she is likely to be the buyer or the seller. In other words, in the beginning, neither Bill nor Carol know whether they will be the buyer or the seller, if a triggering event happens. Consequently, Bill and Carol are more likely to be fair and reasonable in negotiating their buy-sell terms.
Other Important Buy-Sell Provisions
Phantom Income Taxation
Most small businesses are “tax flow through” entities, usually partnerships, LLC’s or S-corporations), meaning each owner must pay income taxes on her share of the company’s profits, even if the company does not distribute all of those profits in that tax year. “Phantom income” refers to income that is reported on an owner’s tax return but not actually received by that owner as a distribution. For example, if Carol owns 60% and Bill owns 40% of their “tax flow through” S-corporation, and the company makes $100,000 in net taxable profits one year, Bill must report and pay taxes on $40,000, even if the company owner paid him $5,000 in profits. Bill has $35,000 of “Phantom Income.” A good Buy-Sell Agreement will protect Bill from the tax consequences of “Phantom Income,” and require adequate distributions to cover those taxes.
A judge from the Indiana Court of Appeals once commented that the only lawsuits nastier and more expensive than marital dissolution cases are lawsuits between business partners. Buy-Sell Agreements help to avoid lawsuits between business partners, because these agreements provide predictable results and fewer reasons to seek relief from a court. A good Buy-Sell Agreement may also require mediation or arbitration as other ways of staying out of court rooms.