We often don't realize we're missing something until we need it most. And so it goes with a buy-sell agreement (often simply called a "buy-sell"). Many construction companies soldier on without one until, sometimes quite suddenly, an ownership change occurs and the business is thrown into chaos.
So if you're missing a buy-sell agreement, it's not too late to get this important matter taken care of. And even if you have, regularly re-evaluating the arrangement is a must.
Stabilizing ownership
Essentially, a buy-sell agreement is a contract among your construction company's owners that sets parameters for the transfer of business interests. It determines the value of the business or defines the valuation method to use, and outlines when and to whom the interests can be sold.
A buy-sell agreement has many benefits. It can help preserve or transition the management and control of your construction company. A buy-sell agreement may also prevent conflicts among the remaining owners and the withdrawing owner's family members, while creating a market for the withdrawing owner's business interest.
If your construction company is family-owned, a buy-sell can be a huge plus, as it can be used to establish a succession plan to safely transfer the company from one generation to the next.
Keeping it funded
Funding your buy-sell agreement ensures that the money will be readily available to cover the terms of the agreement and the purchase. Funding options include sinking funds, loans, savings plans, installment purchases and life insurance. (Your CPA can explain the details of each option.)
Using life insurance to fund your buy-sell is a popular method because it can help ensure that beneficiaries receive the agreed-upon price for the business shares in a timely manner. Life insurance can also provide buyouts that won't put a strain on your construction company's cash flow or force you to sell off assets to pay the bills. And it often preserves wealth and liquidity for the withdrawing owner or the deceased owner's estate.
Drawing it up
When business owners draw up a buy-sell, the arrangement generally takes one of two formats. The first is a cross-purchase agreement, in which the remaining owners buy a departing owner's shares. From a tax perspective, the surviving owners receive a stepped-up basis equal to the purchase price, which reduces income taxes in the event they later sell their shares. Also, because any life insurance proceeds used to fund the agreement bypass the company, those proceeds avoid any corporate alternative minimum tax (AMT) issues.
Cross-purchase agreements are, however, more difficult to administer because each owner typically must maintain separate insurance policies on the lives of all the other owners. So, for example, a cross-purchase agreement for a company with 10 shareholders would require 90 life insurance policies. (Using a separate partnership or trust can solve this issue.)
The second format is called a redemption agreement. Here the company buys back the shares. This arrangement is easier to administer — a 10-shareholder company would require only 10 life insurance policies owned by the company — but it can create tax problems. Surviving C corporation owners don't enjoy the benefits of a stepped-up basis, and the company may be subject to corporate AMT on the life insurance proceeds.
Confronting the task
This article only touches the surface of the complexities relating to buy-sell agreements. But the point remains — doing without (or failing to update) one is far more dangerous than confronting the task of creating a buy-sell.
So even if your construction company is blessed with plenty of work and a healthy backlog, it's worth your while to allocate some time to this issue. And if you're heading into a slow period, here's a good way to occupy your time.
