Buyout traps for privately held businesses

Any business with more than one owner eventually faces the issue of succession, typically in the context of an owner’s retirement, death, or disability. Except in cases where shares are given or bequeathed to family members, it is usually anticipated that shares will be redeemed by the business or purchased by the other owners upon these events. As a business and estate attorney, I often see hidden traps in buyout arrangements.

In situations where there is no formal agreement, most states have “default” rules governing the departure of a business owner. For example, Wisconsin law entitles a departing LLC owner to a distribution in complete redemption of his interest within a “reasonable time.” These rules can create liquidity problems for the remaining members. An LLC operating agreement or buy-sell agreement can be drafted with structured payments to solve the problem.

Legal documents frequently permit (or require) the business to redeem shares of departing owners. This may cause untended shifts in control. Assume Tom and his son, Tom Jr., each own 30 of 100 outstanding shares, and Tom wants his son to eventually have control. Tom’s brother, Dick, owns the remaining 40 shares. Upon Tom’s death, the company redeems Tom’s shares, leaving Tom Jr. with a 42 percent interest (30 of the remaining 70 shares) and Dick with a 57 percent interest. The problem is solved if the agreement requires Tom Jr. to buy his father’s shares directly, rather than having the company buy the shares.

Life insurance is often bought to provide liquidity in connection with the purchase of a deceased owner’s shares. However, policies may be payable to the wrong party (for example, insurance is payable to the business, but the buyout agreement requires the surviving shareholders to buy the shares). In these situations, getting the death proceeds to the “correct” party can cause negative income tax results. Worse yet, the party who receives money from the insurance company may refuse to deliver it to the “correct” party.

Left to gather dust, a business succession plan can become outdated. A special area of concern is valuation, usually addressed in legal documents by including a dollar amount, valuation formula, or procedure (e.g., the parties agree upon an appraiser). Another is the stated term and interest rate under any note owed by the purchasing party. The economic assumptions within the buyout agreement should be reviewed to ensure that they still make sense.

Most buyout traps for closely held businesses are avoidable with proper planning.

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