Pitfalls to Avoid in Your Buy-Sell Agreements

A buy-sell agreement should be in place in every private company with multiple owners, including family-owned businesses. In fact, many professional advisers argue that it’s likely the single most important legal document an owner will sign. Basically, it establishes the “exit rules” when a co-owner chooses—or is forced—to leave the business.

It is a legally binding contract between shareholders and/or partners (owners) of a business that restricts the transfer of their ownership interest to unintended parties. A buy-sell agreement specifies who is allowed or required to buy the departing owner’s shares, which events will trigger a buyout, and what price will be paid for the outgoing owner’s interest. It also provides for an orderly succession plan for the ownership and management of the business in the event that an owner wants or needs to exit.

As important as buy-sell agreements are to the business’s continuity, they can simultaneously create more problems than they solve if they are not drafted correctly or reviewed regularly.

New Legal Developments: The Connelly v. United States Decision

In June 2024, the U.S. Supreme Court issued a landmark ruling in Connelly v. United States which significantly impacts buy-sell agreements—particularly those involving life insurance is as a funding mechanism for shareholder buyouts.

The Court held that life insurance proceeds held by a corporation must be included in the value of the business for estate tax purposes when determining a deceased shareholder’s taxable estate. This decision is a reminder that improperly structured agreements and insurance planning can unintentionally increase estate tax liability for families and business partners.

Key Takeaways from Connelly:

• Valuation Impact: Life insurance proceeds used to redeem shares are included in the company’s fair market value for estate tax purposes.
• Buy-Sell Design Matters: The agreement’s structure, number of shareholders, and insurance arrangements all influence whether the proceeds create unintended tax exposure.
• Accurate Valuation is Critical: Outdated or formula-based valuation methods may no longer withstand under IRS scrutiny.
• Who is Most Affected: Closely held businesses with redemption-style agreements and insurance-funded buyouts should reassess their agreements immediately.
• Next Steps: Business owners should review their agreements with advisors to confirm valuations are current, life insurance is properly structured, and agreements are coordinated with overall estate plans.

As Cory Parnell, Principal at BGM, explains:

“In the absence of a workable agreement, the remaining shareholders and the corporation may be placed in the unenviable position of negotiating under adverse circumstances with former friends, their families, or their estates. The Connelly decision adds even greater urgency for business owners to ensure their agreements are structured and reviewed correctly.”

Common Pitfalls to Avoid

Failure to Include All Potential “Triggering” Events

Triggers are those events that initiate one party’s right or obligation to buy the stock of another party under the agreement. The most common triggering events found in buy-sell agreements are the death or disability of an owner.

What is often overlooked are the more likely “living” events that trigger ownership transfer. These can include retirement, divorce, termination (voluntary or involuntary), declaration of insolvency, illegal acts, and of course, disputes. Yes, the latter do occur – the more inclusive the triggering events, the less likelihood of misinterpretation—or worse yet, litigation.

Inflexible, Cookie-Cutter Valuation

Valuation can be a major source of contention in every buy-sell. One of the most troublesome provisions is tying the valuation to some agreement between owners to be made in the future or according to a schedule (i.e. annually). Owners may not be the best judges of value. Additionally, the agreed-upon price is often not kept up to date. Formula valuations (i.e., book value) may not accurately reflect the reality of the business as it grows.

Valuation tied to an appraisal may be best, but careful consideration of who chooses the appraiser is important.

The Connelly ruling highlights the risks associated with outdated or formula-driven valuation methods. The IRS and courts will consider the fair market value of the business, including insurance proceeds, rather than simply what an agreement states. As a result, valuation tied to an appraisal—kept current and performed by a qualified professional—is often the safest path.

Outdated Documents

Buy-sell agreements should have “sell-by” dates, just like the groceries in our cupboards. When they lie at the bottom of dark drawers, collecting dust, unreviewed, they can yield some ugly surprises when the light of day shines upon them. Changing business circumstances, owner objectives, or worse yet, owner identities, can cause huge problems if not regularly reviewed and updated.

Improper Life Insurance Structure

After agreeing upon whether the buyout shall be mandatory or optional, partial or full, and even on how to value the interest, business owners still must address payment. How will the seller be paid? How might this affect the future viability of the business?

In the event of a death-triggering event, life insurance can provide an immediate, tax-cash payment at precisely the time needed. Is it an option? Is it adequate? Does it last long enough? Is it properly structured? Care must be taken to ensure that the insurance benefit, policy owner, beneficiaries, and premium payers are all properly aligned. Accessibility and unintended tax consequences can result when the life insurance is not properly structured and reviewed.

The Connelly decision underscores that life insurance is not simply a funding tool—it has a direct impact on valuation and estate tax outcomes.

Improper Selection of Buy-Sell Strategy

Buy-sell agreements take three forms.

• Redemption: where the entity purchases the interest.
• Cross-purchase: where one or more persons buy the entity’s interest.
• Hybrids: which mix the two.

When funded with life insurance, cost basis adjustment (or lack thereof), potential Alternative Minimum Tax (AMT) exposure on death proceeds, premium costs, and the number of policies needed are all impacted by the chosen design. Inexperienced owners and advisers, beware.

Failure to Consider Related Properties or Entities

It is one thing to provide for the sale of ownership interests and quite another to consider related property. Related property can include interests in affiliated entities, or an  interest in land or other property co-owned by some or all the remaining owners (such as property where the business operates), or life insurance policies on the life of a selling owner. It can also include intellectual property, leases, or other contractual rights or obligations.

While the buy-sell agreement may not address all these issues, reference to them might offer a fallback if shareholders cannot negotiate an agreeable remedy.

Failure to Coordinate

Many times, business owners think seriously about buy-sell agreements only after they’ve already entered into other agreements that can impact the effectiveness of the buy-sell. Examples include articles of incorporation/organization, partnership agreements, bylaws/operating agreements, loans or security agreements, franchise agreements, and leases. Buy-sell agreements must be coordinated with these other agreements.

Conclusion

Buy-sell agreements are designed to provide an objective means of transferring ownership in controlled and predetermined manner under specified circumstances that may be difficult. In the absence of a workable agreement, the remaining shareholders and the corporation find themselves in an unenviable position of having to negotiate with former friends, their families, or their estates under adverse circumstances. Such negotiations, which would occur after the interests of the parties have diverged, are complex, fraught with uncertainty, and often lead to litigation.

With the Supreme Court’s recent decision in Connelly v. United States, business owners now face an additional layer of complexity. Agreements that once seemed sufficient may expose families and companies to significant estate tax liability if they are not updated.

Review, update, and revise your buy-sell agreements regularly—and especially now in light of Connelly—to ensure your business, your family, and your legacy are protected. Contact us if you have any questions or need assistance with revising your buy-sell agreements.