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Buy-Sell Agreements can be a useful tool for Family Businesses

July 26, 2022

By Maxwell R. Dormer, Esquire

If you are an owner or co-owner of a family-owned business, you should think about having a plan in place that ensures that the business stays within the family after you pass.  Usually, this plan takes the form of a buy-sell agreement whereby your interest in the business will be bought by other members of the family.  With proper guidance, a well-crafted agreement can keep the business within the family, provide funds to the decedent’s estate, and serve to ease the burden of valuing the business for estate tax purposes.

The federal estate tax applies to estates over $12.06 million ($24.12 for couples) in 2022. Estates below that amount are exempt. A person’s taxable estate is calculated using the fair market value of their property at the date of death.  For bank accounts, publicly traded stocks, and real estate the process of determining fair market value at death is usually straight-forward. However, for small to medium sized family-owned businesses, the process can make estate administration ever more complicated.  Fortunately, the tax code permits buy-sell agreements that meet certain requirements to serve as both a means of retaining family control over a business and as a valuation tool for estate tax purposes.

Section 2703 of the Internal Revenue Code permits a buy-sell agreement to serve as valuation for your estate if it satisfies the following requirements: (1) the agreement is a bona fide business arrangement, (2) it is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration, and (3) its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction.  In very basic terms, the agreement must require that the decedent’s interest in the family-owned business is purchased for fair market value, i.e., the price an unrelated person would pay for it.

If a family wants to take advantage of § 2703, there are a few basic pitfalls that should be avoided when drafting the buy-sell agreement. First, the buy-sell agreement should create a set formula or process for determining the business’ value.  No person should have the power to unilaterally change the formula or process during their lifetime.  Second, the formula or process must result in a fair market valuation of the business.  Third, the formula or process must ultimately be followed when purchasing the decedent’s interest in the business.

It is important to note that while utilizing § 2703 can ease the burden of estate administration following the death of an owner, it may not be the best plan for your business or family.    Business succession planning is unique to every business and every family.  It requires careful consideration and proper counsel to ensure that both the business remains in the family and that it continues to prosper after you are gone.  If you are interested in creating a family-owned business succession plan, contact us online or call (412) 338-1100.