Buy-sell agreements plan for the unexpectedBuy-sell agreements plan for the unexpected

Last time, we discussed the benefits of using an entity to manage risk in farming operations. When family members or friends come together to form an entity, it is imperative to have a plan in place to deal with the unexpected.

In this column, we take a look at how effective buy-sell agreements can accomplish that. Specifically, we will apply our analysis to clients Bob and Joe, brothers who have formed a limited liability company to own their farm equipment. Buy-sell agreements allow the parties to set terms that are triggered upon a member’s exiting the LLC. The five main events we plan for in a buy-sell agreement are death, disability, retirement, voluntary leave and involuntary leave.

UNEXPECTED EVENT: Buy-sell agreements can help limited liability companies set terms to best deal with a member's unforeseen departure from the company for one of several reasons.

The first event we address in a buy-sell agreement is death. In the event of a member’s death, the agreement should require that the remaining members purchase the deceased member’s shares and specify the purchase price. Common price determinants are "as agreed upon annually," appraised value of the assets, balance sheet value of the assets or a percentage of one of those figures.

Equally as important as specifying the terms of purchase is funding the buy-sell agreement. This is typically accomplished by the members cross-purchasing life insurance on each other. To fund their buy-sell agreement, Bob and Joe each agree to purchase an insurance policy on the other’s life. Assuming Bob dies first, Joe would use the insurance proceeds to pay off Bob’s estate by purchasing Bob’s shares.

The second event we plan for is disability. An effective disability provision forces a disabled member to sell his shares if he is disabled for a predetermined length of time, typically 12 to 36 months. There should also be an agreed-upon purchase price. Payments are frequently structured on a promissory note ranging from five to 10 years. The buy-sell should specify whether the disabled member will receive a salary during disability, and if so, for how long. The buy-sell should also address the purchase of capital assets.

Let’s assume Bob is disabled. Bob and Joe’s buy-sell agreement specifies that after disability, if Joe wants to buy a capital asset that exceeds a preset amount — say $200,000 — then Bob (or Bob’s spouse, if Bob is incapacitated) must agree to that purchase. If Bob (or Bob’s spouse) does not agree, then Bob will be forced to sell his shares to Joe. This allows the disabled member and his family to avoid undesired risks. Finally, the disability provision should authorize who votes a member’s interests if he becomes incapacitated.

Several reasons to leave

The third event addressed in the buy-sell agreement is retirement. The most important question in this section of the agreement is, what age constitutes retirement? Typically, we see our farming clients choose anywhere between 63 and 70 years old. This does not force the party to retire upon attaining the specified age, it just allows them to retire and leave the LLC without any adverse consequences under the agreement.

Upon triggering the retirement clause, the remaining member is forced to purchase the shares of the retiring member at a predetermined price. The members should specify the terms of the purchase, commonly offered on a promissory note over five to 10 years.

Bob and Joe specify 65 as retirement age in their buy-sell agreement. Bob turns 65 next year and is ready to leave the business and retire to Arizona. Upon retirement, Joe must purchase Bob’s shares for balance sheet value, to be paid on a promissory note over seven years.

The fourth event we plan for is voluntary leave. Voluntary leave occurs when a member leaves the LLC by choice before attaining the age of retirement. When a member chooses to leave prior to retirement, the buy-sell agreement often penalizes the exiting member by specifying that he will receive a reduced purchase price, rather than full value, for his interest.

In their buy-sell agreement, Bob and Joe decide that if a member leaves before the age of retirement, then his shares must be purchased by the remaining member at 75% of the balance sheet value on a five-year promissory note. This provision serves to discourage members who have committed to operating together from leaving the business early.

The final event planned for is involuntary leave. Involuntary leave results when a member is asked to leave the corporation any time before the age of retirement, due to actions deemed detrimental to the LLC. For example, if the member is facing criminal charges or has committed a fraud against the corporation. The buy-sell typically allows for a further reduction in the purchase price as compared to when a member leaves voluntarily.

In Bob and Joe’s buy-sell agreement, they agreed that if one of them is asked to leave under these circumstances, the remaining member must purchase the exiting member’s shares, but at a purchase price of 50% of balance-sheet value.

The best way to plan for the unexpected exit of a member from a business, whether due to death, disability or choice, is to clearly articulate the terms in a buy-sell agreement that is drafted well and formalized early on in the business relationship. If you have yet to create a buy-sell agreement for your business, or you would like yours revisited, speak with your estate and business planning attorney.

Gunsolus is an associate attorney with Miller Legal Strategic Planning Centers PA in Rochester. Contact her at [email protected].