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| Best Practices: Family Business |
Mortal Combat
Kris Frieswick
01/01/2006
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Partners avoid
drafting these agreements for a variety of reasons. Some claim they do not have
the time or money to invest in drafting a comprehensive document, including a
buy-sell agreement. Others may want to avoid the emotionally charged
conversations that can result. “At the start of a partnership, people are in
love,” says Abraham Rudy, a business litigation attorney at Weissmann, Wolff,
Bergman, Coleman, Grodin & Evall in Beverly Hills, Calif. “The last thing
they want to be forced to think about is, ‘What if I get upset? What happens if
you or I steal something? If we split up, who gets the
typewriter?’”
Partnership agreements often fail to contemplate the many
scenarios that can befall a partnership during, and after, the lifetime of its
members. But when partners do finally sit down to write up partnership and
buy-sell agreements, they must remember one overriding principal: No one knows
who will die first, so the agreements apply to every partner—and to the spouses.
“Whatever you want to do for your spouse, you better be ready to do the same
thing for your partners’ spouses,” explains Paul Vogel, CEO and president of
Enterprise Trust, the St. Louis asset management division of Enterprise
Financial Services. “Sometimes partners forget that these agreements go both
ways.”
Values and Valuation
Buy-sell agreements are the centerpiece of any plan
designed to protect the interests of both surviving partners and the spouse of
the deceased in the event of a partner’s death. Such agreements attempt to
balance the desire of a spouse to receive quick and fair compensation for a
husband’s or wife’s life work, with the company’s need to stay solvent.
The
core of the buy-sell agreement is the company valuation. Partners must decide
who will estimate the value of the company, the evaluation method (for example,
whether cash flow and goodwill will be factored into the equation) and whether
or not a liquidity discount will be applied to the deceased partner’s share.
Such discounts often apply when a share would be particularly difficult to sell
to an unrelated third party, which is one of the standards against which fair
market value is judged. “The more specificity you have about the methodology,
the more you’ll have agreement over the basis for the valuation, and there will
be less opportunity for disagreements down the road,” advises Jay Rosenbaum, a
partner at the law firm of Edwards Angell Palmer and Dodge in Boston.
Some
companies assign book value as the valuation methodology, but that has fallen
out of favor with many firms, primarily because the IRS assumes that most
sellers will insist upon fair market value. In fact, the IRS taxes the transfer
of assets in family partnerships at fair value, regardless of what method was
used to calculate the payout. “The IRS assumes that a third party would be more
diligent in getting full value than a family member,” Rosenbaum adds.
Buy-sell agreements also stipulate how the purchase of the spouse’s share
will be financed. Some companies purchase a life insurance policy for each of
its partners that funds, in whole or in part, the payout of that partner’s share
in the event of death. Often, that policy payout serves as a down payment, with
the bulk of the payments coming in the form of a promissory note. The note
outlines the terms of installment payments over time.
In some cases, a
partnership may not have the cash needed to buy out a spouse, now or in the
future, leaving it with no other choice but to make the spouse a partner. This
is usually the last-resort option for both partners and the spouse. Many state
statutes give the surviving spouse the right to ownership of the late partner’s
share, and rights to the income from the partnership, but not managerial rights.
Such an arrangement presents a number of problems, primarily that the spouse
will be subject to taxation on the distribution of the profits from the
partnership, even if the those profits are rolled back into the business.
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