Guide to Buy-Sell Agreements In Your Estate Plan

 

Like it or not, some day control over your properties or your business will pass to others. You can either allow the default provisions of the law to determine who will take control, or you can decide for yourself through proper estate planning. While this is something most people do not like thinking about, proper estate planning is necessary to minimize conflict between your loved ones, reduce taxes, and ensure that your wishes are carried out after your death. 

The principles discussed here apply to ownership of real estate and businesses such as corporations and partnerships. For convenience we will simply refer to "buildings or property" rather than "business" or "shares of stock". 

There are many ways to protect yourself and your property for the long term. Guide to Keeping your Buildings and Your Business in the Family. One way to ensure that your property stays in the family is to keep it in a trust for a period of years after your death before it can be sold or distributed to your named beneficiaries.  Another option is a buy-sell agreement. This article examines how to use a buy-sell agreement to address certain problems that may arise when property is left to siblings or other co-owners.  It does not address all of the concerns typically negotiated in co-ownership agreements. 

What is a buy-sell agreement?

A buy-sell agreement is an agreement you can use as part of your estate planning.  Each agreement will be different and specifically designed to effectuate your particular intent. 

If you own the property by yourself, you will likely use the buy-sell agreement to carry out your wishes after you are dead. The agreement can accomplish this by putting limitations on the future sale or transfer of the real estate. Those to whom you plan to leave the property normally sign the agreement.  Assuming you intend to give the property to your children, the agreement may provide that each child is allowed to sell or transfer their interest during their lifetime, but only to one of the other people named in the agreement (e.g. your other children or grandchildren).  The agreement would also provide a formula for determining the sales price.  If you want to keep the real estate in your family, the agreement may provide that each family member’s will and living trust is to leave the property to the family members of your choice.  Additionally, the agreement may provide that each of your loved ones must own the property as their separate property and take the necessary steps to keep it from becoming the community property of a spouse. 

When is a buy-sell agreement helpful?

Buy-sell agreements are useful if you plan to leave real estate to more than one person in your will and trust. They are useful whenever real estate is co-owned by two or more people. They can also make a big difference when co-owners may face a disgruntled heir. Guide to Preventing Inheritance Feuds with a No-Content Clause. If you own a building (or several) by yourself, a buy-sell agreement can be essential. Consider what will happen when you die or are unable to continue managing your properties. Chances are you have a living trust that leaves the property to your children. However, unless you have one property or other assets of equal value to give to each child, there is a good chance that your plan will have your children co-owning the buildings in conflict with each other.

Co-ownership of real estate brings a host of problems which can be compounded by inevitable sibling rivalries.  Exacerbating the situation is the fact that, unlike most co-owners, siblings typically did not ask to co-own property.  One child might not have the time, skills, or willingness to manage the property.  Another child may want to sell the property and one may be set on keeping the property in the family.  A buy-sell agreement could require one child to offer the property interest to the other at a price you establish before it can be offered to a third party.  This creates an easy out for the child that does not want to be involved, and allows the property to stay in the family and under the management and control of those who are willing and capable. 

A buy-sell agreement is also necessary if you co-own a building with someone outside the family.  If your partner were to die, their share would likely pass to one of their family members. This person may not have the same goals for the property as you do or may not have the same business sense your partner did.  An effective buy-sell agreement will allow you to buy out their interest before it is passed to someone else.  It will allow you to retain control and not suddenly be put into the position of co-ownership with someone you have never met or approved. 

Conversely, assume your partner is alive and well, but that circumstances beyond their control suddenly require them to sell or give their interest to a third party such as a creditor.  You could end up owning property with someone you do not agree with or even know.  If you had an effective buy-sell agreement, you could negotiate all these factors before any problems arise. You could ensure that you had the first right to buy out your partner’s interest.  Negotiating these issues before there are any problems or hardships can make the transition smoother and prevent future animosity. 

A buy-sell agreement can also protect your property in the event a co-owner or beneficiary gets divorced. Under California’s community property system, the property is considered separate property if acquired before marriage or by inheritance, thus the divorcing spouse would generally have no claim to it.  However, even if the property is separate property, the non-owning spouse may have a right to be compensated for work either spouse did on the property, including management and improvements.  If, at the time of the divorce, the owning spouse does not have liquid assets to pay that compensation, he or she may be forced to sell their share of the property to pay it.  A buy-sell agreement can require the divorcing owner to sell their share back to the other owners before offering it to a third party. 

While buy-sell agreements are ideal for real estate, they are also useful in a variety of other situations. Such agreements are particularly useful for any asset that is not easily divided into pieces or that is co-owned. For example, many of the concerns discussed in this article come into play when dealing with a partnership or family business. 

A buy-sell agreement can solve many problems involving co-ownership of real estate.  If a buy-sell agreement is not properly prepared, however, it can create more problems than it solves.  To minimize hardships and conflicts that may arise, it is imperative that you carefully consider the financial implications of a buy-sell agreement.

Valuation

Death, incapacity, and bankruptcy of a property owner commonly call for a buy-out.  The first major consideration is the valuation of the share that is to be bought or sold.  Since the market is constantly fluctuating and you don’t know when the agreement would come into play, it is advisable to decide on a formula for calculating the value, rather than specifying a static dollar amount.

Because there are many ways to value a property, it is important to discuss the alternatives and decide on one at the outset.  For real estate, it is common to name an independent appraiser in the agreement who will determine the fair market value of the share to be sold.  The parties agree to defer to the appraiser’s future determination.  Keep in mind that this figure may be lower than you may imagine.  For example, if you and a partner each own half, the fair market value of that half will be less than half the value of the property because a buyer in the open market will pay substantially less to be a co-owner.  Buy-sell agreements can also use these “valuation discounts” to minimize estate taxes, but that topic is beyond the scope of this article.  

Valuation can be more difficult if the asset is not real estate. Businesses, for example, are commonly valued by a formula based on the average net income of the business. For example, the purchase price may be four times the average net income of the business over the past three years. 

Payment terms

A buy-sell agreement is ideal if you and your partner want to agree not to sell the property.  This can be done by establishing terms of the buy-out that are highly unfavorable to the selling partner.  Consider the schedule for payment.  It is likely that the value of the property is significant, and that the person purchasing it does not have the money outright. To avoid conflict, the agreement may set out how much money is due at the outset, and make provisions for how many installments will be due.  For example, you could require 10% down, and a promissory note for the balance to be paid in twenty equal annual installments with interest equal to the prime rate.

Keep in mind that a buy-sell agreement is only one part of your estate plan and that other documents and actions are required to take care of your loved ones.  Proper estate planning now can go a long way to ensure that your hard earned property goes to your loved ones on your terms. 

 

© 2012 John E. O’Grady & Katherine M. Watts

The information contained in this article is general in nature and should not be relied upon for any specific situation. Consult a qualified attorney for any specific legal advice.

 
 
 

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