With over 4.4 million partnerships in the U.S. alone (and $3.9 trillion in income passed through to partners in 2021), it’s clear that a multitude of businesses have plenty on the line when it comes to their inevitable transitions and dissolutions, including CPA firms like your own. In our last article, we showcased how key-person insurance can help protect your business from the unexpected, especially vital as you near your own exit from the company. However, it’s not the only tool in your CPA toolkit, especially if you have partners. In this article, we’ll demonstrate how buy-sell agreements can help shore up your mitigation strategies and prevent your business from being blindsided by legal challenges.
What is a Buy-Sell Agreement?
So, let’s talk buy-sell agreements. Basically, it’s a legally binding contract that protects your firm (and thus your retirement) if a partner passes away, decides to retire, or just rides off into the sunset. Think prenup–but for a business. They help ensure a smooth transition of ownership and keep unwanted third parties from swooping in when a partner’s stake becomes available, such as an estranged spouse or a disinterested relative who might sell their share to an unknown party or even a competitor. Instead, the agreement requires that the available share be sold to the remaining partners or the partnership itself.
How a Buy-Sell Agreement Works
Buy-sell agreements smooth transitions in ownership when a partner dies, retires, or abruptly leaves the business. They prevent outsiders from sneaking into the ownership structure and set a method to determine each owner’s worth. In this way, in the case of a partner’s sudden departure, a buy-sell agreement ensures your business’s continuity and ownership structure.
Instead of a partner selling their shares to an outside party (or a family member), a buy-sell agreement requires the shares to be sold to the company or remaining partners based on a predetermined formula. Life insurance policies often fund these buyouts. In a cross-purchase agreement, each partner buys insurance policies on the others, with themselves as beneficiaries.
In an entity-purchase agreement, the business owns the policies on each partner and is the beneficiary. Upon a partner’s death, the insurance payout goes directly to the surviving partners or the business, providing funds to buy the deceased partner’s shares from their estate. This arrangement helps avoid conflicts with heirs, probate, and potential disputes.
Do You Need a Buy-Sell Agreement if You Don’t Have a Partner?
If you’re a sole owner, it might seem like a buy-sell agreement isn’t necessary—after all, the business is entirely yours. However, estate planning tools, such as a will or trust, may not cover all aspects of the business’s transition if something unexpected happens. Things can quickly get complicated if your untimely passing leaves the business without a guiding hand, and you want to ensure a key employee takes over to ensure smooth sailing.
Types of Buy-Sell Agreements
As we’ve mentioned, buy-sell agreements dictate how a partner or owner’s shares will be purchased. With that in mind, these contracts can fall under one of four primary types, and which one to use depends largely on the party that’s doing the buying.
#1. Cross-Purchase Agreements
The remaining partners each buy a share of the available interest on a pro-rata basis.
#2. Redemption or Entity-Purchase Agreements
The business buys the partner or owner’s interest.
#3. Hybrid Approach
Obtainable shares are divided, with one part going to the partners and the rest for the business to buy.
#4. Wait-and-See Agreement
See what happens, and only at that point will it be decided whether the partners or business will make the purchase.
Keep in mind that a buy-sell agreement doesn’t automatically provide the funds needed to buy out an owner’s shares—it simply establishes the terms. In a cross-purchase agreement, for instance, the remaining partners are responsible for purchasing the departing partner’s shares and must raise the cash to do so. Ultimately, you’ll want to work with an attorney, your own CPA, and possibly an insurance agent to create a buy-sell agreement that’s tailored to your business needs and ensures funds are available when needed.
What Is Included in a Buy-Sell Agreement?
Buy-sell agreements can vary depending on the business owners’ needs and state laws. Generally, they should include the following information:
- A list of the partners or owners involved and their current equity stakes
- A recent business valuation, which is used to place a value on each partner’s interest
- A breakdown of who buys and acquires what
- Events that trigger a buyout, such as death, disability, bankruptcy, or retirement
- How the buyout would be funded—for example, via insurance policies, cash reserves, or third parties
- Tax and estate planning considerations for the individual partners and surviving beneficiaries
Potential Drawbacks of a Buy-Sell Agreement
Another factor to consider is that a buy-sell agreement is a legally binding document that restricts you from selling your interest to anyone not specified in the agreement. But that’s the point of it, right? To prevent just anyone from obtaining shares of your practice? Well, yes, but it also means that if new opportunities arise, your options may be limited, and any changes to the agreement must obtain the mutual consent of all parties involved.
Additionally, the purchase price set in the agreement may become outdated over time, making regular reviews essential—much like keeping a prenuptial agreement up to date. This can mean periodic and potentially costly reviews with a lawyer after major life changes that you or your partners experience, such as divorces, changes in insurance premiums, tax laws, or business valuations.
The Bottom Line
Business continuity is important, especially when there are multiple partners or important equity holders involved in the running of a CPA practice. A buy-sell agreement lays out clear terms and conditions regarding the purchase or sale of a business’s shares so that when the time comes, there’s no legal wrangling or disputes. The last thing you want is for an outside party to come in and mismanage your firm or disrupt the practice you’ve worked so hard to build, especially when retirement is on the horizon.
At CPA Retirement Solutions, we can help you incorporate your buy-sell agreement and its funding mechanisms into your broader retirement and financial plan. Just get in touch by pressing the button below, and we’ll be happy to help you out!
