Dairy Excel: Buy/sell agreements are smooth business transition

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Tax time stimulates many farm owners to consider estate planning and the long-term future of their farm businesses. One of the much needed issues for many small businesses is the plan to continue the business if one of the owners should unexpectedly leave the business. A carefully drafted buy/sell agreement can help with this process.

Guaranteed plan. A buy/sell agreement is an arrangement between two or more parties that obligates one party to buy the business and another party to sell the business upon the death, disability, or retirement of one of the owners.

The agreement is designed to cause a smooth transition following the departure of a business owner. It allows the owners to consider how they want their business to proceed under a variety of circumstances.

Death, disability and retirement are normally thought of as triggering events for a buy/sell agreement. However, a buy/sell agreement also may be triggered by a third-party offer to purchase, divorce, a creditor’s judgment, bankruptcy, or termination. Some eventualities can be provided for with insurance, others cannot.

Crucial to success. The process of developing a buy/sell agreement is usually initiated by the business owner at the suggestion of family members, an attorney, accountant, life insurance agent or lender. One or all may be concerned about the potential business continuation problems and will suggest a buy/sell agreement as part of a business and estate plan. The choice of professionals to help set up an agreement is crucial to its ultimate success.

The usual purposes of the buy/sell agreement are:

* To ensure the ownership and control of the firm remains within the family and perhaps certain employees;

* To provide someone to buy when owners of the business or their heirs need to sell;

* To establish a “fair” value for the interest in the firm; and

* To provide funding mechanisms, or payment terms and conditions, for the purchase of an interest in the business.

Buy/sell agreements have been designed to meet many different family and business needs. The possibilities are only limited by the imagination and the ability of the business and family to fund them.

Common types. One of the more common types of buy/sell agreements is the “cross purchase agreement,” under which each business owner buys life insurance on the lives of the other owners.

Under an “entity purchase agreement,” the business itself is obligated to purchase the ownership of a deceased or leaving owner. Frequently these are at least partially funded by the firm buying life insurance policies on each of the owners.

Another example is a “no-sell, buy/sell agreement” where the remaining owners remain in control of the business and the leaving owner or his or her heirs retain their share in the business, but control of the business remains with the owners who are still in the business. It also may provide some funds to the leaving owner or his or her heirs.

The “wait and see purchase agreement” allows the parties to structure the transaction at the time of the triggering event.

Limitations and concerns. One of the greatest advantages of the use of life insurance in a buy/sell agreement is its ability to immediately provide funds should one of the parties die unexpectedly. But, life insurance only provides cash in the case of a death. It does not provide money due to disability, retirement, divorce, a creditor’s judgment, bankruptcy, or termination. One can purchase disability insurance, but for the other possibilities the owners will need to find non-insurance sources of funds to cover them.

If a business is successful and grows over time, growth and inflation will likely make the original life insurance policies inadequate in 10-15 years. While it is possible to initially purchase insurance, which can be increased over time, the increase is usually limited and, in reality, many people do not increase it or take other action to meet the shortfall.

Another concern is the cost of all the life insurance needed to fully fund a buy/sell agreement. It is not uncommon for the annual premiums for all the life insurance policies on all the owners of a small business to cost tens of thousands of dollars. When a business is doing well, the business and family members may have no trouble making the premium payments; however, if business does not do well it may place a considerable burden on the family and business to pay life insurance premiums. For this and other reasons, most life insurance policies are canceled before the insured dies.

Something else. Therefore, in the long run, most business owners should make arrangements to fund at least part of the buy sell agreement with something besides life insurance.

Other likely sources of cash include investments, liquidation of assets, and payment plans, which allow business owners to make payments to the departing business owners or their heirs over time. Business owners also may want to reduce their interest in the business by selling or giving away some of their business interest.

Buy/sell agreements are important documents that can help in the smooth transfer of a business from one generation to the next. Due to their complexity and the many options available the choice of professionals to assist with selecting and implementing a buy/sell agreement is crucial. Life insurance is a valuable tool for funding a plan, but life insurance has limitations and usually should be supplemented with other funding sources.

(The author is the northeastern Ohio farm management specialist with OSU Extension. Questions or comments can be sent in care of Farm and Dairy, P.O. Box 38, Salem, OH 44460.)

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