Buy Sell Agreement – Funded or Not Funded

BARRY: My name is Barry Haimo. I’m excited to have this opportunity to work with Chad. We’ve been really kicking around ideas on how to bring value to people and share our knowledge and what gets us excited about what we do.

Particularly what I do and what we do at our firm is estate planning and business planning. It’s a niche practice in the sense that it’s wills, trusts, probate, business planning, and asset protection, but it’s a big universe in between.

We help families plan for disability, death, wealth preservation, and protection, and help them avoid a lot of the common pitfalls that happen either unknowingly or as a result of poor planning. 

Chad and I have joined forces, and we’re excited to bring you a series of several videos on the various topics that relate to estate and business planning for business owners. And today, Chad is going to tell us about his top 10 list that we came up with for business owners from his perspective.

CHAD: Thanks for teaming up. While you were talking, I realized I didn’t really mention where my area of specialty is. I’m kind of the perfect counterpart to Barry, because while he focuses on the legal implications, and to some extent the financial implications, of a lot of things he talked about that he does, I really focus on working with business owners and high net-worth individuals on the financial implications of a lot of things that go on throughout the business lifecycle.

Predominantly, dealing a lot with how you exit the business in the correct way and set yourself up to do so in the most efficient way possible, while taking into account the tax implications of such transactions of such life events. And over the next series of videos and hopefully today, I’ll give you a little more insight into some of the things that I’m talking about. Today, the top 10 issues I encounter typically when working with my clients in these areas. Thank you for the kind reminder, Barry.

BARRY: I still think that’s not enough, though. You have like 17 degrees. Tell us the degrees. You’re a CFP or a CPA or a JD? Come on.

CHAD: I think my wife and my dad wouldn’t let me hear the end of it if I went and got another degree. But Barry’s correct. I have a unique background as a financial advisor in that I practice in two disciplines. Actually, two professions. Prior to really proactively working on the financial side of things, I’m still both a licensed CPA and a licensed attorney. 

So the knowledge that I share with my clients really takes into account those different areas in the financial advice that I give. And it’s one of the reasons I enjoy working with people like Barry. We can speak the same language with our clients and really create that team atmosphere that in today’s complex landscape is really needed. You really need all of your advisors coordinating and working together to make sure that the advice that they are giving you is cohesive, not contradicting each other, and is taking into account all aspects of your plan, not just focusing on a rate of return and things of that nature.

BARRY: I would say the same thing. In our practice, we coordinate with professionals. We call it the “trifecta of representation.” It’s a team sport in our minds. We completely agree philosophically in how we approach professional planning. So it’s a true treat to do this with you today. 

If we’re going to jump in with your Top 10– I believe we both agreed to reserve the right to add. To make it more than 10. But basically the point is to talk about it. We’re just having fun talking about what we like to do and how we help people. 

All right. So, I have the list. Are these in order?

CHAD: They are not in any order. Kind of the same way you said we reserve the right to add things to this list.

BARRY: Okay. 

CHAD: I was just free-flowing. We were just talking about, really, some of the top 10 things that I encountered. Ironically enough, most of these top 10 mistakes are avoidable if you’re just being proactive about them. But these were just kind of ad hoc. These are the things that stand out to me and were most pressing in my mind right now.

BARRY: And the ones that are bolded, why are they bolded?

CHAD: They really get me fired up, Barry. I’ve seen through personal experience – whether it’s family or things that have occurred in my life – and it really gets me energized because I know I can help people avoid them.

BARRY: I’ll have to bold my list next time. All right, so let’s jump in. We’ll go in order, but they’re not in any order. 

CHAD: What you’ll find, too, is a lot of them kind of work together. Some of them fit together. Like a financial plan. You know, all the pieces fit together. So it’s only natural that some of the mistakes can be grouped together as well.  

BARRY: Right. And I guess after we’re done, we can put together some sort of list. Like a bulletpoint list to give to people to download if they want.  

CHAD: Absolutely.

BARRY: All right, so number one: having a buy-sell agreement but not funding it. Or funding it but not having a buy-sell. What’s that all about?

CHAD: Well, I can’t tell you the amount of times that I meet with clients and they’ve met with someone like yourself and they say, “We have our operating agreement in place. We have our buy-sell agreement in place.” Which, by the way, that could be another mistake itself, people thinking they’re the same thing.

But they have their buy-sell agreement, but they don’t really think about what would happen if they need to act upon that buy-sell. And so, just a quick example is, let’s say that you have a business worth $5 million with two partners. So naturally each partner would have about $2.5 million of equity in the business. 

But let’s say it was a business that was very illiquid. Maybe they’re in real estate. Or maybe a lot of it is accounts receivables. There are different things where there is no real cash in the business. They’ll come to me and say, “I have this agreement.” And I’ll say, “Great, what happens if your partner can’t work anymore?” That’s another mistake, that most people only take into account one aspect of a buy-sell – the death, typically, not the disability.

So what happens if one of your partners gets disabled or passes away? Do you have enough cash in the business to be able to buy out that partner’s spouse or whoever their significant other or heir to their legacy is? And if there’s not enough cash in the business, that could be a really big issue. Especially if you don’t like your former deceased partner’s spouse. Most people don’t like being in business with their former deceased partner’s spouse, especially when that spouse may not know anything about the business, but could have a lot of influential control in the decision-making because of the equity their former spouse had.

And so that agreement, you can really wipe your you-know-what with it, because there’s nothing in there to actually effectuate the transaction.

BARRY: So let me kind of piggyback that with a little bit more of a question. When I do shareholders’ agreements – buy-sell agreements – I structure them in a way where I’m contemplating a few different scenarios. One is that there’s no insurance – i.e., they blew it in funding it the right way. Leveraging their capital the right way. In other words, minimizing or reducing the financial burden of having to deal with that buyout later. That’s really the issue. 

CHAD: Do it for pennies on the dollar now proactively as opposed to dollar-for-dollar later on.

BARRY: I don’t do pennies. It’ll end up being what it has to be financially. But in one scenario where there’s no adequate funding, I usually build in a provision where they come up with a value. There’s a procedure for coming up with a fair value, and that’s another whole video, how we do that, and which ones wind up in litigation versus the other ones. 

But once you identify the value, we come up with a payment plan. Kind of like buying a house. Percentage down, balance paid or amortized over a period of time. And if it’s long enough, it softens the financial burden. 

But I think you bring up a good point. If there’s no cash flow, you’re not going to be able to pay those payments. It’s just not going to happen. And so that’s gonna cause a problem. There’s gonna be a breach of the agreement. And you’re gonna end up being partners with the estate, the spouse, the beneficiaries, the trust – whatever it is. And that is not ever appreciated.

CHAD: I’ve seen it a lot where two brothers are in business with each other and the spouses can’t stand each other. And it’s ironic that they’re all family, but that happens a lot.

BARRY: All right. So on one hand we have the scenario where there’s no funding, but we do have a buy-sell. The other scenarios I have are if there’s funding and if there’s inadequate funding. So if there’s funding, it’s beautiful, because it executes swiftly and smoothly. Can you shed light on what that looks like if it’s done the right way?

CHAD: Sure. It’s like you said. It’s as smooth as can be. It would be no different than having life insurance on yourself. Something happening to you and your wife getting paid out. You know, it’s filing a claim. You collect the the proceeds. You pay out the party that should be paid out and you effectuate the legal side of the agreement that you help your clients get. It makes it a lot easier, a lot smoother.

BARRY: So the deceased– or maybe disabled, depending on if it’s a disability-triggered buyback. The deceased or disabled partners or their estate receives the payout from insurance.

CHAD: Well, it really depends how it’s structured, because it could be that the proceeds could go into the actual entity and that’s used to buy the equity out from the person. So, it may not flow directly to the spouse, but it really depends on how the actual agreement is structured.

BARRY: I think if it’s a flowthrough, like an S corp or a partnership, it’s always going to be outside rather than if it’s a C corp. But regardless, generally speaking, the money kind of goes to the departing shareholder in exchange for the stock.

CHAD: Correct. 

BARRY: Stock comes back either to the company if it’s a C corp or to the other shareholders if you have the pass through, right?

CHAD: Yep.

BARRY: Okay. All right.

CHAD: You know, it’s not bleeding the capital dry of the company, which is a big issue that happens. But it’s not adequately funded. You had mentioned inadequate funding, that’s when you actually start in to the capital of the business, and that could really have an effect on the ongoing sustainability of the business in terms of going forward.

BARRY: Right. So to give more context there, in that third option where there’s inadequate funding– You have funding, the partners were smart, they got a valuation. Like a real valuation, not a Mickey Mouse valuation. Somebody who actually does that work. They get a valuation, it will hold up for tax purposes. It’s right. It’s accurate.

But then 3, 5 years later, they’re growing and their business has tripled. They have inadequate funding now. They haven’t revived the conversation with you to update their funding needs. So that’s an example of having inadequate funding. Right?

CHAD: Right. That’s why I advocate and I urge and attempt to communicate with all my clients about the the importance of having an annual review, so we can have these conversations, see if the value of the business has changed, and then make those adjustments accordingly ahead of time as opposed to realizing that you’re really behind the ball on what you could have done for yourself.

BARRY: Right? One of the things I do for for my early stage businesses – startups and early stage, actual operating businesses – is, in that that first scenario where maybe there’s not enough money for funding yet, it’s just not economical? I’ll do a small down payment of the value once the value is computed, and I’ll spread out the payments a long time – five or 10 years, quarterly, subject to interest at the AFR. And the reason why I do that is to minimize or mitigate the financial burden to the company to have to pay that out. 

Because the company needs to be able to survive to pay that out. And it’s in both parties’ interest for the company to succeed and continue and thrive for those payments to be made and the company to continue to be in business.

CHAD: I can elaborate on that too. Another way, when there really is inadequate funding in the beginning, is you can fund this– It’s never the recommended way long term, but you can temporarily fund these agreements with a temporary term policy. 

Typically, these buy-sells are done with permanent insurance when you’re funding them. But you can do it to bridge the gap from a funding standpoint with convertible term insurance. So that when the capital of the business allows, you can then convert that to the permanent vehicle so that it’ll be sustainable for the long term of your business. 

BARRY: Not a convertible term. I remember learning about that. Okay. We could spend a whole session on this topic I’m about to say, but let’s not do that. Just quickly, like very, very Twitter summary. When you talk about the permanent whole life, whatever you call it, is that where you’re kind of maximizing the overfunding to avoid becoming characterized as a modified endowment contract mech and utilizing the cash value versus the death benefit? Is that one of those plays, or is that a different concept? 

CHAD: So that really depends on the way you structure these permanent plans, whether it’s overfunded or not. Really depends on what the ultimate use of the vehicle is. Because one of the great things about a permanent vehicle, while the buy-sell is in place, the business actually can utilize the cash value, if necessary in the plan, for business purposes. It’s an asset on the books of the business that, one, they they can utilize. It strengthens their position when going to sell. But yes, they can use the cash value for business purposes. 

And then if the agreements are structured correctly, these things can actually also be used as 

supplemental retirement for the partners, where let’s say 15 years down the road the business sells, and then they decide to transfer out the policies from the business to the partners individually. Well, all of a sudden now it’s either a supplemental retirement vehicle – tax-free, by the way – that their family could use, or if they don’t need the cash in there, it’s a death benefit now for their family as opposed to the the remaining spouse.

BARRY: When you say tax-free, is that because it’s a loan against the policy?

CHAD: Yeah. It depends. Obviously, tax-free depending on how you you access the funds. And although it is true that first it’s a withdrawal and then it’s a loan above that withdrawal, up to what

you put in, and then a loan above that, you actually don’t end up having to pay this loan back. The dividends of the policy go back to paying the loan. Or ultimately you can just not pay it back and the death benefit that goes to the family will be reduced by the outstanding loan. 

But in times like we’re experiencing with market volatility right now, it provides a real nice “call our flock to safety,” if you will, where if you’re in retirement, you don’t need to be accessing funds from a equity based retirement account. You can allow those accounts to grow back up, absorb the losses, and access your funds here.

We could have a whole entire 10-hour video on this. On how it maximizes your overall wealth distribution. But I think it’s just important to know that it’s another asset class and a tool in the tool shed that can be used to maximize your overall wealth distribution planning.