Buy-Sell Agreement Fundamentals: Proven Protection
We can't predict the future, but we can plan for it. To help your business run smoothly and continuously, you should consider a Buy-Sell Agreement. These agreements help you out if you or a partner decide to leave your real estate investment business, die, or cannot participate in the company.
A Buy-Sell Agreement is a contract that benefits any business that has partnerships. These agreements answer any question about the company's operation going forward and mitigate the harm of someone unexpectedly leaving the partnership for any reason.
What Is A Buy-Sell Agreement?
A Buy-Sell Agreement is legally binding and determines what happens to a partner's share of the business if the partner leaves or dies. The agreement is designed to protect all partners in the company equally and is a reliable way to secure the future of your business.
It might be helpful to think of a Buy-Sell Agreement as a business prenup that stipulates how a partner's share of a business may be reassigned or sold to other partners if a partner:
- Dies
- Becomes temporarily or permanently disabled
- Divorced
- Files for bankruptcy
Other names for a Buy-Sell Agreement include a buyout agreement or a business will.
Why Should I Create A Buy-Sell Agreement?
A funded Buy-Sell Agreement has multiple benefits that protect your business because the agreement:
- Handles the sale of shares easily
- Prevents unwanted ownership situations
- Can provide extra sources of capital
- Mitigates potential tax liability on the decedent's estate
- Provides funds to the family of the deceased partner
- Creates financial stability which can be essential for obtaining traditional bank financing that can be used for the business to grow
Handles the sale of shares easily
The agreement provides the business with the following:
- A ready market of buyers (the remaining partners)
- Preset valuation of the businesses shares, or a way for the valuation to be set
The other partners in your business are motivated buyers and know exactly how much the leaving partner’s shares are worth. Because that pricing has been agreed upon the sales process goes more smoothly and the family of the partner that has passed on gets a substantial payout that helps the family to maintain, grow and ease the pain of their loss.
Prevents unwanted ownership situations
A Buy-Sell Agreement keeps the shares between partners or within the business. By design, it prevents:
- Unwanted, outsider ownership
- Concentrated ownership of shares by one partner
- Creates a triggering event for sale and the means to buy the share
- Keeps family members from having to step into a business that they know nothing about and have to make decisions that they are not qualified to make
Can provide extra sources of capital to grow the business
One possible funding source comes from Cash Value Life insurance policies taken out by the business on each partner. When you use a life insurance product to fund the agreement, these agreements can help the business grow by utilizing the cash value of an insurance policy.
By utilizing life insurance to fund your Buy-Sell agreement, when/if something happens to one of the partners in your business the Life Insurance policy has a death benefit that is going to pay out enough money that the partners that are still working in the business are able to purchase the shares of the partner who is no longer.
Mitigates tax liability
If you have an agreement in place and a partner dies, the IRS will view the sale as authentic and not a disguised gift. It helps the decedent's estate avoid potential gift tax.
Who Funds a Buy-Sell Agreement?
Businesses often use buy-sell agreements to make transitions more manageable when a partner dies or leaves the company.
Usually, a Buy-Sell Agreement stipulates that the business share be sold to the company or remaining partner(s). That begs the question, who pays for the shares?
One option is that the partners buy life insurance for each other. The company can pay for the life insurance policies and claim it as a business expense.
When a partner dies, the life insurance will pay out a death benefit to the other partner(s). The partners will use the proceeds of the death benefit to buy the dead partner's shares from their estate. Thus, the business continues to operate, and the ownership is consistent.
A particular category of insurance, Key Person Insurance, provides an additional layer of protection to your company.
What Is Key Person Insurance?
Key Person Insurance is a life insurance policy that protects the business from losing an essential partner or person. It's a meaningful way to protect the daily operations of your business.
When a key person like a founder or owner dies, the company typically is in dire straits because of the death:
- Wipes out 60% of sales
- Cuts jobs by 17%
- Lowers the likelihood of the business surviving by 20%
Key Person Insurance protects the business by:
- Creating available cash so the company avoids a forced sale of assets
- Providing a cash infusion to the business to offset the loss in revenue from the key person's death
- Covering the Key Person and delivering value through the Cash Value of the life insurance
Keep in mind that you will need to undergo periodic insurance reviews to determine the amount of coverage necessary for each key employee.
Protecting Your Business
| Old Way | Old Result |
| Trust that a family member can take over for you automatically upon your death | Key Person’s death causes a revenue drop by 60% on average |
| Partnership without a Buy-Sale Agreement | Lose key employees |
| Only mandatory insurance policies | Family and partners are left to pick up the pieces of a broken business |
| New Way | New Result |
| Legal agreements that plan for a partner's death or disability | Smooth transition in case of tragedy, can be used for death or disability |
| Includes a life insurance policy to ensure cash is on hand | Cash allows the business to survive |
| Made with attorney oversight | The business owns Cash Value life insurance which can be used as collateral to obtain financing |
Key Insights and Takeaways
A Buy-Sell Agreement determines when and to whom you can sell your part of the business. It also specifies an agreed-upon price and fair conditions for sale.
A life insurance policy guarantees there is cash to execute the agreement if there is a death or disability.
Typically, a disability is more likely than death, and it has virtually the same impact on a business. Funding for disability is an added layer of protection for you and the company.
You can set up policies to provide a dividend as a deferred compensation plan. That plan supplements retirement income (SORP, SERP) and provides a death benefit.
Do you have questions about how to protect your real estate investment business?
Royal Legal Solutions has answers! Read about some common issues real estate investors face and how we can help you secure your financial future.