There are nearly 32 million small businesses in the United States, according to the Small Business Association. Of those, 81% are single-person entities with no employees on the payroll. According to PNC, while 60% to 70% of small business owners want to pass along their business to the next generation, only 15% have an actual succession plan in place.
Having a succession plan in place protects the value that you build in your business so you can have a more secure retirement, and also protects your family in the event of your untimely death. A succession plan also ensures your clients are taken care of.
With tax changes afoot, you might want to sell your business before the end of the year. If you want to set up a buy-sell agreement and engage in the sale of your business before tax laws change and capital gains rates go up, this article provides a basic framework for you.
Why the Focus on Buy-Sell Agreements Now?
The American Families Plan put forth by the Biden administration includes a proposal to raise the capital gains tax to 39.6% for the range starting at $1 million. However, the newest proposal did not go anywhere near this rate, with the Ways and Means Committee releasing a plan with a top rate of 25%, up from 20% today. Additionally, if passed, this rate would potentially start for all capital gains transactions after September 13, 2021. While this won’t impact most Americans, it could impact people who are selling their businesses. But even if there is no change in the law regarding capital gains, prudent succession planning remains valuable today.
These potential changes might create an environment where more business owners will want to sell their business before the end of the year. Maybe you are one of them.
Here’s a quick overview of the main things to consider when entering into a buy-sell agreement:
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- Who? Who is the right person to purchase your business? Is it somebody internal? Are you looking at an acqui-hire (acquiring a company that will take over eventually)? Do you want to sell and exit the business?
- Cultural fit. Does the person looking to purchase your firm share the same business values (like adaptability, follow-through, etc.)?
- Legal structure. What type of buy-sell agreement do you want to enter into? More on this in the coming sections.
- Trigger event. What is the event that’s going to trigger the buy-sell agreement? Is it retirement, death, disability, divorce, a set amount of time, termination of employment or a voluntary sale?
- Funding. How are you going to fund the purchase when you leave the business? Are you going to use credit or cash? Life insurance?
In the coming sections, we’ll dive a little bit deeper specifically into the last three points.
Types and Legal Structures of Buy-Sell Agreements
There are several types of buy-sell agreements, including:
Let’s look at an example of three business partners – partners A, B and C – who enter into a cross purchase buy-sell agreement. This means they have equal ownership rights – one-third each. If A dies – a triggering event – then B and C have agreed to purchase equal shares of A’s ownership interest, such that B and C are now 50% owners of the partnership.
A cross purchase works best with three or fewer owners. More than likely, the agreement is structured such that the purchasing owners receive a step-up in basis. Also, if the remaining owners receive life insurance benefits from the deceased owner, these are received income tax free and don’t increase the value of the business.
However, a cross purchase gets 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 each other. But if there are more than three partners, the formula is (No. of Partners – 1) x No. 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 starts getting messy.
As the business gets bigger, we might instead consider any of the following types of buy-sell agreements.
This means the actual entity is going to purchase the share of the deceased or departing owner. Back to the three-partner entity example: If A dies, B and C won’t get any new shares in an entity purchase buy-sell agreement. The entity itself purchases A’s shares, and B and C still have one-third ownership each. But functionally, they are still equal owners of outstanding shares.
In this type of agreement, the remaining owners are less likely to get any step-up in basis, and assets that are available to fund this purchase are now held at the corporation level, so any life insurance held there could be subject to corporate creditors.
In some states, however, an entity itself cannot own assets, so be mindful of your state’s rules.
Right of first refusal
This means the seller can go shop the business around to third-party markets after the triggering event. The buyer with the right of first refusal has the option to match any offer at its terms or with more favorable terms. The challenge here is it’s hard to match terms if the agreement is drawn up well.
Right of first offer
This means that you have the right to buy before anybody else. The common language in this type of buy-sell agreement protects the buyer, and oftentimes there is a time period in which they’ve got to make a decision.
Hybrid and other options
Forced buy-sell agreements are when the triggering event triggers a structured sale. There isn’t a right of refusal on either side.
You could also go the route of a pure time-bound buy option. In this case, you’ll need to have the buy-sell agreement lapse at some point because there are rules of perpetuity. For example, in a pure buy option, you have the right to buy into a company as long as a certain owner is still alive.
In any buy-sell agreement, you must consider the triggering events. Improper selection of triggering events is among the biggest mistakes people make in buy-sell agreements. These include:
- Voluntary sale
- Bankruptcy of a shareholder or member
- Termination of employment (you must distinguish with or without cause)
One of the best parts of a buy-sell agreement is that it allows us to set the funding and valuation of the company. For valuation, typically we’ll use a formula – usually EBITDA multiplied by an industry multiple. Sometimes, businesses will do an appraisal by an outside company. Valuation is an important part of a buy-sell agreement, as it will determine how the business will be priced and what funding the buyer will need.
There are several options for funding.
Earn-out installment sales might become more favorable should capital gains taxes increase to the 39.6% or even the 25% proposed rates. For example, if you sell a business worth $5 million, you might want to structure the payments to be $1 million per year for five years to avoid losing maybe 5% to 20% of the $4 million subject to capital gains taxes if you receive the payment all at once. This type of planning would become even more important if the higher capital gains tax is applied to all capital gains if you are even $1 of adjusted gross income over the $1 million threshold.
Above, we talked about life insurance. You can get a life insurance policy on key persons in the entity. Complete financing is guaranteed from the beginning, and death benefits are free from income tax. This is generally the most economical approach, as premiums are a fraction of the death benefit.
Sometimes, depending on the triggering event, you might need to borrow funds to complete a purchase if you are the buyer.
Businesses can be strengthened by having the appropriate buy-sell agreement in place. But oftentimes, people make mistakes in structuring them that cause issues.
Common mistakes include not considering the tax implications of a sale, designating an improper trigger event, failure to formalize the plan into a legally binding contract and failure to update the plan over time as the business changes.
While it looks like a change to a top rate of 25% rate is more likely than 39.6%, both are just proposed rates at this point and any changes would need to be watched closely as bills move forward in D.C. However, if the current proposal goes through, the date would already be set for September 13, 2021, so planning is a must now!
Contact your financial services professional or attorney for guidance if you find yourself in a position to sell or buy a business in 2021 or beyond.