The business itself may also suffer from a supplier’s or creditor’s perception of the value of the deceased person to the success of the business. Key employees may consider the deceased’s death as a reason to move elsewhere. There needs to be continuity and a smooth transition in the business when tragic events such as deaths or disabilities occur. The buy-sell agreement is important to resolve a lot of problems dealing with employees, creditors, suppliers and the deceased person’s family.
Importantly, where will the funds come from to provide continuity and a smooth transition? Everyone is going to die and sometimes it happens totally unexpectedly and at a much younger age than expected. There are no dying rules specific to owners, partners and shareholders. Stuff happens!
A buy-out sell agreement is, essentially, the will for the business and it eliminates a lot of difficulties and heartaches when a key person dies. A plan needs to be in place and a method of funding that plan must also be available.
There are several options for business owners to fund a buy-sell agreement:
- They can wait and see - “I’ll worry about that if and when it happens.” A sole proprietor can say, “I’ll be dead, so no reason for me to worry about it.” Sure! If it is a partnership, the partnership dissolves automatically and, “My partner will do the right thing.” Is that what you want? You can use your personal funds to buy-out your partner’s stock. But what if it comes at a bad time? Your personal stock portfolio is down, you’ve got two children in college, and you’ve had to take less income from the business lately because business has been in a slump. Maybe, after a lengthy probate the corporation can buy the stock and place it into treasury stock, if funds are available. But where does this leave the family of the deceased? Would you leave it up to your partners to do the right thing for your family no matter what the personal cost would be to the partner?
- They can borrow funds - obviously, borrowing funds is not an option to a dead sole proprietor. Could a key employee put together the money to purchase the company? Can the surviving partner(s) borrow enough to purchase the assets of the deceased partner? Maybe they can take out a second mortgage on the house? Maybe the lost one is the one depended upon by bankers and suppliers. Maybe the repayment and interest is simply too burdensome.
- They can set-up a savings account within the company - This could be done in anticipation of an event like this happening but, again, if you are a corporation there may be accumulated earnings tax problems and if you are not a corporation, it may be difficult to maintain a savings account or the death may occur prematurely before enough funds are available.
- They can buy life insurance - Let’s look at this from a sole proprietor’s, a partnership’s and a corporation’s perspective.
Sole Proprietor
Unless a sole proprietor (let’s call the person an “owner”) has a family member or a close relative to turn the business over to and feels comfortable the owner’s desires for his/her family members will be served, the options are limited. The business can be closed, it can be sold to an outsider, although small businesses are sometimes difficult to sell, or, if the owner wants his ‘baby’ to continue, it can be sold to one or more competent and faithful employees. The buy-sell agreement to a trusted employee becomes a two-step plan:
- An agreement is prepared which sets forth the employee’s obligation to buy, the price the employee(s) will pay for the business and the method of payment.
- The employee takes out a life insurance policy on the owner. The employee is the owner of the policy, the person who pays the premiums and the beneficiary. If the owner dies, the death benefits of the insurance policy would be used to buy the business from the owner's estate.
