The Small Business Administration statistics show that more than 32 million small businesses operate in the United States. 81% of those are sole proprietorships with no workers. While 60% to 70% of small business owners would like to pass on their business, just 15% of those owners have a succession plan in place, according to PNC.
Protecting your business’s value ensures that you can enjoy a more comfortable retirement and also safeguards your family in the event of your death. You can ensure that your customers are well taken care of with a succession plan.
With tax changes on the horizon, you may wish to sell your company before the end of the year.
This blog post will give you a basic framework if you want to set up a buy-sell agreement and sell your business before tax rules change and capital gains rates rise.
How Do Buy-Sell Agreements Affect the Market?
There is a 39.6% capital gains tax proposed in the American Families Plan by the Biden administration for anybody making above $1 million. However, the Ways and Means Committee released a plan with a top rate of 25%, up from the current 20%, which is a far cry from this new idea.
After September 13, 2021, if this rate is passed, it could apply to all capital gains transactions. This will have little impact on the majority of Americans, but business owners considering a sale may be impacted. However, even if capital gains laws stay unchanged, careful succession planning is still important today.
Because of these possible alterations, more business owners may decide to sell their company before the year is up. Is there a chance you are one?
5 elements to keep in mind when engaging in a buy-sell agreement
Who is the ideal buyer for your company? Is it someone internal?
#2: Cultural compatibility
Is the person who is interested in purchasing your company a good fit for your company’s values?
#3: Structure of the Law
Is there a type of buy-sell agreement you’d prefer to sign?
What will cause the buy-sell agreement to go into effect? There are several reasons why someone might want to sell their business: retirement, death, disability, divorce, or the end of their career.
How will you be able to pay for the purchase? What kind of payment will you use for the purchase? Cash, credit, or Life Insurance?
Take a closer look at the 5 different Buy-Sell Agreement legal structures and types below.
5 Buy-Sell Agreement Legal Structures and Types
Buy-sell agreements come in a variety of forms, including:
Three company partners, A, B, and C, enter into a cross-purchase buy-sell arrangement, as shown in the following example. As a result, they each own one-third of the business. Assuming A passes away, B and C have agreed to buy equal shares of A’s ownership interest, making them each 50% proprietors of the partnership in the event of A’s death.
For a cross-buy, there should be no more than three owners. The arrangement is most likely constructed in such a way that the purchasers obtain an increase in basis. To top it all off, any life insurance proceeds received by co-owners after a deceased owner’s death are tax-free and don’t add to the company’s overall value.
More than three owners complicate a cross-purchase, though. In our original scenario, for example, A, B, and C each buy a life insurance policy on the other person. The formula becomes (Number of Partners – 1) x the number of partners if there are more than three partners involved. The four partners would therefore need 12 life insurance policies if there are four people (3×4). There are a total of 90 life insurance policies needed if there are 10 partners (9×10). It gets a little more complicated.
As the company grows, we may want to look into one of the following buy-sell arrangements instead.
#2: Entity Purchase
Essentially, this means that the actual company will buy out the deceased or departing owner’s portion. Another example of a three-partner company: if A dies, B and C will not receive any new shares under the buy-sell arrangement of an entity acquisition. A’s shares are purchased by the company itself, but B and C retain a one-third stake each. But in practice, they are still equal shareholders.
Remaining owners are less likely to get any base increase, and any life insurance carried at the company level is now vulnerable to corporate creditors, making this form of agreement less desirable.
It’s important to remember that an entity may not be able to possess assets on its own in some states.
#3: Right of First Refusal
This means the seller might then begin looking for buyers for their firm after the catalytic event. A buyer with the right of first refusal can match any offer at its terms or with more favorable terms. Assuming the agreement is properly drawn up, however, it’s challenging to match terms.
#4: Right of First Offer
This means you have the option of purchasing the item first. The buyer is protected by the use of common language in this form of the buy-sell agreement, and there is generally a time limit for them to make a decision.
#5: Hybrid and Other Options
When a triggering event causes a structured sale, a forced buy-sell agreement is in place. On either side, there is no right of veto.
It’s also possible to choose a time-limited buy option. The buy-sell deal will have to be terminated at some point because of regulations of perpetuity. You have the right to buy into a firm in a pure buy option as long as the owner is still alive.
The catalysts must be taken into account in any buy-sell agreement.
The most common mistake in buy-sell agreements is to select the wrong “triggering” events.
These triggers include:
- Bankruptcy of a member or shareholder
- Termination of employment (once distinguished if with or without cause)
For one thing, a buy-sell agreement gives us control over the company’s financing and valuation. An outside entity may be hired to do an evaluation on behalf of a business. A buy-sell agreement’s valuation is critical because it will decide how much money the buyer will need to buy the business and how much the seller will get for it.
Financing is available in a variety of forms.
If capital gains taxes rise to 39.6 percent or even 25 percent, it may be in the best interest of buyers of earn-out installment sales to do so. When selling a firm for $5 million, you might wish to structure the payments to be $1 million a year for five years to avoid losing 5% to 20% of the $4 million liable to capital gains taxes if you receive the cash all at once. Capital gains tax planning will become much more critical if the threshold of $1 million in adjusted gross income is exceeded even by a single dollar.
It is possible to obtain life insurance on the company’s most important figures. There is no income tax on the death benefits, and the financing is assured from the beginning of the contract. This is frequently the most cost-effective alternative because premiums are a fraction of the death benefit.
If you are the buyer, you may need to borrow money in order to complete the transaction.
Final Word on Having A Buy-Sell Agreement In Place
To help firms develop, you should have a buy-sell agreement in place. However, many people make mistakes when it comes to arranging them, which can lead to problems.
Issues may arise if tax implications of the sale, designating an incorrect “trigger” event, neglecting to formalize the strategy, or failing to update the plan as the business develops over time are common blunders.
A change to a 25 percent top rate is more plausible than 39.6 percent, but both are simply suggested rates and any adjustments would have to be closely monitored as D.C. laws proceed through the legislative process.
If you’re planning to sell or buy a business in the future, you should speak with a financial advisor or an attorney.