Estate planning is essential to managing your assets and ensuring your loved ones are cared for after your death according to your wishes. But, as a business owner, what happens to your ownership interest when you die? Does your family inherit your interest in the business, along with your obligations? Are they expected to participate in the company? Or will your heirs inherit the cash value of your interest? And who determines the value of your interest and how your heirs will be paid?

For many business owners, these estate issues and other complexities can often be addressed through a Buy-Sell Agreement.

What is a Buy-Sell Agreement?

A Buy-Sell Agreement is a legal agreement between co-owners of a business that outlines the terms and conditions for the purchase or sale of a business interest in the event of specific triggering events, such as death, disability, or retirement. The agreement provides a roadmap for what happens if an owner wants to leave the business or is forced to leave due to unforeseen circumstances.

Why Should You Use a Buy-Sell Agreement in Estate Planning?

There are several benefits to using a Buy-Sell Agreement in estate planning, including:

Clarity: Ensuring that business interests are transferred according to the owner's wishes: A Buy-Sell Agreement provides clarity on how the transfer of ownership will take place and who will take over the business.

Preventing Disputes:  Without a Buy-Sell Agreement, there can be confusion or disagreement about what happens to the business after an owner leaves or dies. This often leads to costly legal battles or even the dissolution of the company.

Providing Estate Liquidity: If a business interest is a significant asset in an estate, it may be challenging to generate the necessary funds to pay estate taxes or distribute assets to heirs. A Buy-Sell Agreement can provide a guaranteed sale of the business interest at a reasonable price. This ensures that the estate receives the value of the business interest and provides liquidity for the estate.

Facilitating the Purchase: A Buy-Sell Agreement drafted by a qualified California estate planning attorney can make selling or buying a business interest easier. The terms and conditions are pre-negotiated, and funding mechanisms can be established beforehand.

What Should be Included in a Buy-Sell Agreement?

A Buy-Sell Agreement drafted by a qualified California business or estate planning attorney should include the following:

  • Triggering Events: Certain events will trigger and activate the agreement. These include death, disability, retirement, or a desire to sell the business interest.
  • Valuation Method: Detailing the valuation method avoids confusion and helps eliminate future arguments. The valuation method can be a formula, a third-party appraisal, or another method agreed upon by the parties.
  • Terms: The terms and conditions for the purchase or sale of the business interest should outline the rights and obligations of each party. This included the timeline for the sale, the payment terms, and any restrictions on who can purchase the business interest or how it is transferred.
  • Funding: The funding mechanism for purchasing the business interest can include using life insurance proceeds, personal funds, or establishing a sinking fund to accumulate the necessary funds over time.
  • Rights and Obligations: The rights and obligations of each party typically include provisions related to voting rights, transferability of the business interest, and any other relevant matters.

What Triggers a Buy-Sell Agreement?

Buy-Sell agreements are used in business for many purposes. In estate planning, the typical triggering event is the death of an owner or partial owner of the company. The death signals the beginning of the buy-sell transaction between the company and the estate according to the terms of the agreement.

However, there are other triggering events. If an owner becomes disabled, a well-drafted Buy-Sell agreement will have provisions for the remaining owners to buy the business interest of the disabled owner. This helps provide for the financial needs of the disabled person and their family.

And often, a business owner wants to retire from their involvement in the company. Most Buy-Sell Agreements cover this contingency and allow the retiring owner to sell their interest back to the company at a pre-determined price and terms. Or, the agreement might allow the remaining owners to find a suitable buyer.

What are the Main Types of Buy-Sell Agreements?

Buy-Sell Agreements are used by small and large businesses. And they can be simple or relatively complex in companies with many key employees. Some of the main types of Buy-Sell Agreements include:

Cross-Purchase Agreements: In this agreement, the remaining owners purchase the deceased owner's interest in the business. The arrangement is usually funded by each owner taking out life insurance policies of the other owners. 

This type of agreement is accomplished when each owner takes out a life insurance party on the others to fund the business interest purchase after death. Cross-purchase agreements are often used in smaller companies where there are few owners. 

For example, if the business has 3 owners, each partner, member, or stock owner will take out two (2) cross-purchase agreements on the other owners for 6 cross-purchase agreements. If there are many owners, these can get quite complex.

Entity Redemption Agreements: Most larger companies use this type of agreement. Here, the business entity agrees to redeem the business interest of a departing or deceased owner. As with the cross-purchase agreement, the future value of the purchase is determined at the time of the agreement signing.

Hybrid Agreements: Sometimes, a company will use aspects of both cross-purchase and entity redemption agreements.

Wait and See Buy-Sell Agreement: The business gets the first option to purchase the departing owner's shares in this agreement. If the company chooses not to purchase, the remaining owners can buy the business interest.

How do you Fund a Buy-Sell Agreement?

Death and disability are usually unexpected events and often occur when we are unprepared to deal with them. This is true in families and businesses. But since these events trigger the Buy-Sell Agreements, it is crucial for the company to have the funding mechanism in place in advance.

There are several funding methods the business can use to facilitate the purchase or sale of a business interest in a Buy-Sell Agreement, including:

  • Life Insurance: Life and disability insurance policies are popular in funding Buy-Sell Agreements. In the case of death and disability, these policies provide all the funding needed to complete the purchase. Using life and disability insurance enables the agreement to be funded with premium payments to ensure the funds will be available when needed. The cost and availability of the insurance depend on the owners' age, health, and the type and amount of insurance purchased. 
  • Personal Funds: Owners sometimes agree to use personal funds to purchase the departing or deceased owner's business interest.
  • Sinking Fund: A sinking fund can be established to accumulate the necessary funds over time to purchase the business interest of a deceased, disabled, or departing owner.
  • Set aside funds. Owners may establish an account for the agreement and set aside these funds in a special account. This option is rarely used because most owners would rather use the capital in their business than hold it in an account.
  • Borrowing:  The company can borrow money when needed. But losing one of the owners can often severely affect the company's financial situation and ability to borrow funds at that difficult time.

Why Use  a Qualified California Estate Planning Attorney

Every state, including California,  has unique laws, rules, and regulations regarding Buy-Sell Agreements used by company owners for estate planning.

For example, Buy-Sell Agreements may be affected by the California Corporations Code, the California Probate Code for partnerships and LLCs, or the California Uniform Limited Partnership Act. And if the company is larger and more complex, the agreement may be subject to California securities law.

Working with an experienced California business and estate planning attorney is essential when drafting a Buy-Sell Agreement. This ensures the agreement is legally enforceable and the business owner's wishes are carried out.

Should a Buy-Sell Agreement be Part of Your Estate Planning?

If you are a business owner in California, a Buy-Sell Agreement should be part of your estate planning. This agreement can clarify what happens to your business interest should you die or become disabled. You can put the funding methods in place now and give you and your family the peace of mind that comes with being prepared for the unexpected.

A Buy-Sell Agreement can be an essential part of your California estate planning.

Choosing the best estate planning tools and strategies for you and your family is complex and confusing for most families. What type of business entity should you choose? Which type of trust is best for you? How do you maximize your asset and liability protection while minimizing your taxes?

These are important decisions that can seem overwhelming. Advanced planning with a qualified California estate planning attorney is always the best option.

Let us help you choose the best options for you, your family, and your business.

At San Diego Legacy Law, our trust attorneys work closely with clients to evaluate their personal goals and available assets before incorporating trusts into their estate plans. Our founder, attorney Nicole D'Ambrogi, holds an LLM in International Taxation with concentrations in Financial Services and Wealth Management, which allows her to strategically analyze the many variables that can affect your ability to meet your estate planning goals instead of focusing on simple document preparation.

San Diego Legacy Law serves clients throughout San Diego and those in La Jolla, Del Mar, Rancho Santa Fe, El Cajon, Poway, Spring Valley, Chula Vista, Santa Rosa, Petaluma, Novato, and Healdsburg.

Contact us today to schedule a consultation to discuss your estate planning and asset protection needs.