In situations where you have more than one owner of a business, it is prudent to have a process in place to manage the exit of an owner, or even the addition of a new one. Many business owners do not appreciate the idea of being forced to have a new business partner without a very important say in any decision. For instance, what if one of the owners dies and the spouse of that owner then takes an active role in the business?
But what is a buy sell agreement? A buy-sell agreement is an agreement which by means of put and call options, binds the continuing owners of a business to purchase a departing owner’s interest on the happening of a specific event. The events that trigger the buy-sell agreement are commonly the death or the total and permanent disablement of one of the owners.
The buy-sell agreement works in either of the following ways:
- where by exercising a call option, the continuing owners force the departing owner or his/her legal representatives to sell his/her interest to the continuing owners
- where by exercising a put option, the departing owner or his/her legal representatives compel the continuing owners to purchase the departing owner’s interest
The agreement may be drafted in a way that applies to any business structure such as a partnership, a unit trust or a proprietary company.
Generally, the buy-sell agreement is fully funded by the proceeds of a life insurance policy providing for the departing owner or his estate to be paid an amount equivalent to the departing owner’s interest in the business in the event of his/her death or total and permanent disablement.
In the case of a business carried on by a corporate entity, a buy-sell agreement may take the form of a cross-purchase agreement, where the continuing owners purchase the shares of the departing owner or a redemption agreement, where the company buys back and cancels the departing owner’s shares or in the event that the proceeds of the insurance policy are insufficient to meet the full purchase price of the departing owner’s shares, a hybrid cross-purchase/redemption agreement, where the company buys back and cancels any remaining shares not purchased by the continuing owner.
Operation of a buy-sell agreement
The buy-sell agreement deals with the procedures for giving effect to the agreement such as how the value of the interest is to be determined, how the payment is to funded and how the interest is to be transferred.
The buy-sell agreement usually provides for the market value of the interest of the departing owner to be determined by agreement, failing which it is valued by an independent expert whose determination is binding on the parties to the agreement.
The agreement may be drafted to operate in a variety of ways. If a business is carried on by a corporate entity, it may be designed to operate in the following manner:
- the continuing owners must purchase some or all of the shares of the departing owner, at least to the value of the proceeds of the life insurance policy
- the purchase price of the shares is their market value less the proceeds paid to the departing owner or his/her estate from the life insurance policy. The proceeds of the life insurance policy (if any) are paid to the departing owner or his/her estate. The market value of the shares is then reduced by the amount of the payment, with the reduced amount being the purchase price of the shares
- if the market value of the shares is greater than the proceeds of the life insurance policy, the continuing owners may choose, but are not obliged, to purchase any portion of the shares representing the difference
- if the continuing owners do not purchase all of the shares of the departing owner, the company must buy back the shares that are not purchased by the continuing owners, conditional on a unanimous resolution of shareholders at a general meeting approving the terms of the buy-back agreement
- if the market value of the shares is less than the proceeds of the life insurance policy, the difference is not refunded by the departing owner or his/her estate
If the company has a constitution, it may preclude or impose restrictions on a share buy-back. It is the duty of the directors to ensure that a share buy-back does not cause the company to become insolvent.
Ownership of the insurance policies and taxation
Depending on the business structure and the manner in which the buy-sell agreement operates, the insurance policies may be self-owned by the owners or taken out over the lives of the other owners or they may be owned by the company or by a trustee of a superannuation fund. In the case of a corporate entity, the buy-sell agreement may provide that the company pays the insurance premiums.
The ownership of the insurance policies and payment of the insurance proceeds on the occurrence of a triggering event will raise various taxation issues including:
- whether upon the death of a owner, the payment of the proceeds of the insurance policy to a nominated beneficiary is exempt from capital gains tax
- whether the payment of total and permanent disability benefits under the insurance policy to a departing owner is subject to capital gains tax. If so, it may be necessary to ensure that the net insurance proceeds are sufficient to fund the purchase of the shares and to meet any potential tax liability
- the buy-sell agreement may provide that where the insurance proceeds are paid to the departing owner or his/her nominated beneficiary, the purchase price of the shares is reduced by the amount of the payment and the shares of the departing owner are transferred to the continuing owner for nominal consideration. If the ATO were to take the view that the continuing owner acquired the shares for no value, the continuing owner will potentially have a capital gains tax liability, if he/she later disposes of the shares
- deductibility of the insurance premiums
The owners of a business should obtain legal and tax advice as to the most appropriate arrangements for their particular circumstances before entering into a buy-sell agreement.
Foulsham and Geddes notes that this article is written for the purpose of providing generalised information and not to provide specialised legal advice. If you require qualified legal advice on anything mentioned in this article, our experienced team of solicitors at Foulsham and Geddes are here to help. Please get in touch with us on 02 9232 8033 today to make an enquiry.