This is the second part in a two-part series on buy-sell agreements. To view the first part, please click here.

The One-Way Buy-Sell Agreement

For companies where ownership is vested exclusively in one individual, there is often a need to address continuity of the company in the event of the sole owner’s death or incapacity. The surviving spouse of an owner may not want to be encumbered with a business foreign to him, and an unclear line of succession could lead to in-fighting or panicking among employees at all levels of the business; in this way, an asset that has produced income for loved ones in the past now becomes a potential liability.  Although practitioners might conceive of buy-sell agreements as occurring between two or more owners of a business, planning in this regard is equally important for enterprises with only one owner.

Regardless of funding method, a Buy-Sell Agreement could be structured as either an entity purchase or a cross-purchase (between the equity holders). Tax-wise, the clear advantage lies with the cross-purchase structure for the reasons we detailed above; not only does insurance provide tax advantages in the form of preferential treatment for its inside buildup and death benefit, but it also facilitates achievement of Section 1012 cost basis for newly purchased equity. Without insurance, a cross-purchase arrangement might not have adequate funding, which could leave the less beneficial entity purchase as the only option. Not only would this sacrifice important tax benefits, but any installment obligation to the seller would remain on the books of the company as a liability, with the debt service crimping net income.

Take triggering events as an example. Most practitioners think of death, disability, and retirement as the only triggering events in buy-sell planning, but these are three of over a dozen possibilities, including:

• Bankruptcy
• Divorce
• Commission of a Tort, such as Discrimination or Sexual Harassment
• Commission of a Crime
• Commission of a Bad Act Bringing Disrepute to the Business
• Professional Malpractice or Loss of License
• Disloyalty to the Business
• Poor Performance
• Material Breach of Company Policy or the Governing Agreement

Each of these, if included, would require careful drafting to address definitions, mechanics, consequences, and other peripheral features. For instance, some of these triggering events might warrant a punitive purchase price or even the surrender of equity. The events arising from bad conduct or poor performance could easily spur litigation if the method for determining their occurrence has any wiggle room.

Another example of an overlooked issue is a default remedy in case an owner does not perform under a purchase note or a shareholder agreement. Should remedies be different depending on the nature of the breach? (We would say yes.) Should certain defaults have a cure period?  (We would also say yes.)  What about monetary penalties, such as default interest? (Perhaps a remedy should include seizure of the equity collateral instead.) These are questions the owners and their advisors must also answer for a Buy-Sell Agreement to work as well as it can.

We hope this article conveyed valuable information, but the biggest takeaway may well be that the area of buy-sell planning is both deep and wide. No single practitioner could possibly understand all of the concepts in detail, which is why a team approach is crucial; and a team could spend a long time working through issues large and small, which is why a buy-sell plan merits revisitation and revision every few years. With the upcoming generational shift in American wealth, which includes a massive transfer of business equity, smart buy-sell structuring will be more meaningful than ever.

Joshua P. Friedlander is the founder of ArisGarde, a wealth advisory and insurance structuring firm. Joshua advises on financial, estate, and business planning matters for families and corporations across various industries including construction, healthcare, staffing, real estate and the clients of law and accounting firms. He focuses on insurance designs and investment strategies to be integrated as part of business succession and executive retention for business owners and their key employees.

Matthew E. Rappaport, Esq., LLM, is vice managing partner of Falcon Rappaport & Berkman PLLC and he chairs its Taxation and Private Client Groups. He concentrates his practice in taxation as it relates to real estate, closely held businesses, private equity funds, and trusts & estates. He is licensed to practice in New York and is an active member of the American Bar Association Section of Taxation, where he serves on the Sales, Exchanges, and Basis committee. 

Daniel J. Gershman, JD, is a Law Cler –Admission Pending–in the Corporate & Securities Practice Group of Falcon Rappaport & Berkman PLLC (FRB). Daniel will focus his practice on domestic and cross-border corporate and securities law matters and related tax issues. He also works closely with FRB’s Taxation and Private Client Groups assisting with structuring and compliance matters involving closely held businesses, real estate and trusts & estates.