by DeEtte L. Loeffler, J.D., LL.M., Taxation
If you own a small business, whether a partnership, limited liability company, or an S corporation, you will likely chose your partners carefully and would prefer not to add new partners without your prior consent. Changes in partners can be sudden (for example, as the result of a death) or gradual (for example, due to the diminishing interest or capacity of a partner). Whatever the reason for the change, you want to be prepared for it so that it will not unduly impact the business and its value.
One way to prepare for this change is to put a “buy-sell” agreement in place. This agreement provides the terms that will apply (and the price to use) in the event a partner dies, becomes disabled, loses his or her interest in a divorce or bankruptcy, retires, or just wants to transfer the interests to someone else. It can also apply in the event of irreconcilable differences between the business partners themselves.
For example, assume A and B, who are married, establish XYZ Properties, a limited partnership. A and B have two children, C and D, each of whom is married and has children. Over time, A and B make gifts of limited partnership interests to C and D, who work in the family business. After A’s death, A’s remaining interests in XYZ pass to a marital trust for B, with C and D, or their issue, as the successor beneficiaries of that trust. C then gets a divorce and C’s children go to live with his former spouse, R (whom no one likes). If C suddenly dies in a car accident, while the children are minors, R will suddenly control C’s partnership interests (as guardian for C’s minor children) unless the partnership agreement grants the other partners a right to buy C’s interests.
Buy-sell agreements should always include certain key provisions. First, the agreement must provide under what circumstances the interests of a partner may (or must) be bought. These “triggering events” usually include such events as bankruptcy of a partner, transfers to third parties without the consent of the other partners (or at least the majority-in-interest), divorce (where a spouse obtains the interests), or the death or disability of a partner. They may also apply in the event one partner wishes to leave the partnership or terminate it, and the other wishes to continue the business.
Second, they should include a method of determining the value of the partnership interests to be transferred that is fair to the seller and the buyer. If a firm price is set, this price may become unfair over time as the value of the partnership changes. For this reason, a formula may be a better method of determining value although these too may fail to adjust as the partnership changes over time. Many agreements require the partnership to value itself annually and to agree on a price per interest to be used that year for any such sales. Annual review provisions are a great idea, but unfortunately partnerships often fail to follow them until after a dispute (or other triggering event) occurs. A more flexible method of setting the value is to require the purchase price be the “fair market value” of the interest as determined by a neutral appraiser (or by the average of three appraisals, where each party chooses an appraiser and these two appraisers then jointly choose a third one to evaluate the business).
Third, the agreement should provide who the buyer will be. The agreement will either provide for the entity to buy the interests (and “redemption agreement”) or permit the other partners to purchase them (a “cross-purchase agreement”).
Fourth, the agreement must define how the sale is to be handled. The agreement can provide (1) that a sale is mandatory, (2) consist of a “put” right (i.e., a right to demand to buy the interests), or (3) consist of a right of first refusal (i.e., a right to purchase before the interest can be transferred to a non-partner).
Fifth, the agreement should be funded. Most often this can be done with life and disability insurance on the partners, but such policies should be periodically evaluated to determine if they are still sufficient. Such funding is effective in the event a partner dies or becomes disabled. However, if the buy-sell is triggered for another reason (such as a bankruptcy or divorce), there must still be a way for the other partners to purchase the interest. If liquidity is likely to be a problem, the agreement could provide for a portion of the purchase price to be paid up front, and the remainder paid in the form of a promissory note.
If you are in a partnership, you should review your partnership agreement to determine if you have a buy-sell agreement, and what the terms of that agreement are. If the agreement was entered into a long time ago, you should also review it to determine if the provisions for settling the sale price are still appropriate. If an annual review and agreement of price is required, you should include this determination in the minutes of the annual partnership meeting (or a special meeting) to document the decision made. If for some reason your agreement is insufficient, you should amend the agreement before a triggering event arises.
If you have questions about partnerships or how your current partnership agreement works, you should seek advice from an experienced attorney. Miller Monson is proud to have supported small business owners and their entities for over 60 years.