Advanced Considerations in Drafting and Funding Buy–Sell Agreements
A closely held business often represents the majority of an owner’s net worth, yet many succession plans fail because the buy–sell agreement is either incomplete or inadequately funded. For attorneys and CPAs advising business owners, careful attention to structure, valuation methodology, and liquidity planning is critical.
1. Choice of Agreement Structure
The optimal framework depends on ownership composition, tax objectives, and anticipated exit strategies:
Cross-Purchase – Each owner agrees to purchase the departing owner’s interest. Basis step-up is achieved at each owner’s level, but complexity increases with multiple owners.
Entity (Stock-Redemption) Purchase – The company redeems the interest. Simpler in multi-owner scenarios, but may reduce corporate liquidity and can affect the remaining owners’ basis.
Hybrid/Wait-and-See – Provides flexibility to allocate purchase obligations between owners and the entity after a triggering event.
Counsel should coordinate these structures with the client’s overall estate plan, including marital and GST considerations.
2. Valuation Mechanisms
The IRS will look to the agreement for determining fair market value if certain conditions of §2703(b) are satisfied:
Agreement must be a bona fide business arrangement,
Must not be a device to transfer property for less than full and adequate consideration,
Terms must be comparable to similar arrangements entered into by unrelated parties.
Periodic independent valuations or formula pricing (e.g., multiple of EBITDA) should be documented to avoid disputes and maintain defensibility for gift and estate tax purposes.
3. Funding Strategies
Even a perfectly drafted agreement is ineffective without immediate liquidity. Common approaches include:
Life Insurance – Provides income-tax-free death proceeds under IRC §101(a). Ownership and beneficiary designations must align with the chosen agreement structure to avoid transfer-for-value issues and potential inclusion under §2042.
Disability Buyout Insurance – Ensures capital for a forced transfer due to long-term disability, a more common trigger than death.
Sinking or Side Funds – Useful for planned retirements but may present earnings and accumulation tax implications.
Regular reviews are essential to confirm coverage remains adequate as company value grows.
4. Coordinating with the Estate Plan
Integrating the buy–sell agreement with the owner’s broader estate plan helps:
Equalize inheritances among heirs who are not active in the business,
Provide liquidity for estate tax obligations,
Avoid inadvertent related-party transfer issues that could trigger gain recognition.
Key Takeaway
For professional advisors, the buy–sell agreement is not a stand-alone document but a multi-disciplinary plan requiring synchronized legal, tax, and financial expertise. Early collaboration between attorney, CPA, and financial planner is the best way to ensure enforceability, tax efficiency, and funding adequacy.
Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate.
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