Business Succession and Buy-Sell Agreements

For a business owner, the business is often the largest asset and the one least ready to change hands. If an owner dies, becomes disabled, divorces or simply wants out, someone has to decide who gets the shares, at what price, and where the money comes from. Without a plan made in advance, those questions are answered by surviving family members and co-owners under stress, sometimes in court, while customers and staff wonder whether the business will last. This chapter covers the buy-sell agreement at the centre of most succession plans, how to set a price, how to fund the purchase, and the estate tax rules that apply when a business makes up much of an estate.

The events a plan has to cover

Succession is not only about death. A sound plan names what happens on each of these events, sometimes called the five Ds:

• Death of an owner.
• Disability that stops an owner from working, defined precisely, with a waiting period.
• Divorce, so that an ex-spouse does not become a co-owner.
• Departure: retirement, resignation, or being fired for cause.
• Disagreement between owners that cannot be resolved.

Each event may justify different terms. A departure for cause might use a lower price or longer payments than a death, for example. Owners also have to decide whether a sale is optional or mandatory, since a family left holding a minority interest in a company it cannot sell or manage is usually better off with a guaranteed buyer.

Ownership succession and leadership succession are separate problems. Someone may inherit the shares without being able to run the company, and the best manager may not be a family member. Many plans name a successor manager years ahead and train them, whoever ends up owning the shares.

The buy-sell agreement

A buy-sell agreement is a contract among the owners, and usually the company, that says who must or may buy an owner's interest after a trigger event, at what price and on what terms. Three structures are common.

Cross-purchase. The remaining owners buy the departing owner's interest personally. Buyers get a new, higher tax basis in the shares they buy, which reduces tax if they sell later. When funded with life insurance, each owner holds a policy on each other owner, which becomes unwieldy beyond two or three owners.

Entity purchase, or redemption. The company buys back the interest. It needs only one policy per owner and is simpler to administer, but remaining owners get no basis increase. Since the Supreme Court's decision in Connelly v. United States (2024), there is an important estate tax catch: life insurance the company receives to fund a redemption counts toward the company's value for estate tax, and the obligation to redeem the shares does not offset it. That can raise the value of a deceased owner's shares, and the estate tax on them, compared with a cross-purchase.

Hybrid or wait-and-see. The company gets the first option to buy, the other owners the second, and the company must buy whatever remains. Choosing at the time of the event lets owners pick the better tax result then.

Setting the price

The most common source of conflict is price. Agreements generally use one of three methods:

• A fixed price that the owners agree and sign each year. It is simple, but owners often forget to update it, and a stale figure can be far from the real value.
• A formula, such as a multiple of earnings or book value plus adjustments. It updates itself, but a formula that suited the business ten years ago may not suit it now.
• An appraisal by an independent valuation professional at the time of the event. It is the most accurate and the most expensive, and the agreement should say how appraisers are chosen and how disputes are settled.

Whatever the method, the price in a buy-sell agreement among family members is not automatically accepted for estate tax. Under section 2703 of the tax code, the IRS can disregard it unless it is a bona fide business arrangement, not a way to pass shares to family for less than their value, with terms comparable to arm's-length deals.

Paying for it

A buyer who has agreed to buy needs the money. The main sources each trade cost against certainty.

Life and disability insurance. Policies on each owner pay the purchase price at death, and disability buyout policies at disability. Insurance creates money exactly when it is needed; premiums cost money every year, and owners who are older or in poor health may find cover expensive or unavailable.

An installment note. The buyer pays over time with interest, out of the business's profits. The example below shows what that means for a buyer.

Buying a share valued at $1,500,000 over 10 years at 6.0% interest costs about $16,653 a month, $1,998,369 in all, of which $498,369 is interest. The selling family depends on the business staying profitable for ten years without the owner who built it, which is the main risk of this route. Security for the note, such as a pledge of the shares, protects the seller.

A sinking fund. The company or owners set money aside each month to build the buyout fund.

Setting aside $5,000 a month at an assumed 5.0% builds about $1,324,123 after 15 years. That works for a planned retirement many years away but leaves nothing near enough if an owner dies in year two, which is why many plans combine a fund for retirement with insurance for death and disability.

Exits outside the family

Many owners have no family successor. Common alternatives are a sale to key employees, often financed partly by the seller, a sale to a competitor or private buyer, and an employee stock ownership plan, a retirement plan that buys the owner's shares on behalf of the employees and has its own tax rules. Each takes years to prepare. Clean financial records, a management team that can run the business without the owner, and contracts that do not depend on one person all raise the price a buyer will pay.

Estate tax when a business dominates the estate

Most estates fall under the federal estate tax exclusion of $15,000,000 per person in 2026, but a successful business can push an estate over it, and a dozen or so states levy their own estate tax at much lower thresholds. If a closely held business makes up more than 35% of the adjusted gross estate, section 6166 of the tax code lets the estate pay the estate tax on the business portion in instalments over as long as fourteen years, so heirs are not forced to sell the business to pay the tax. Lifetime gifts of shares, often combined with the trusts in chapter 8, can move future growth out of the estate.