Does my business need a buy-and-sell agreement?

Key takeaways

  • Death and disability may result in a co-owner of a business exiting it unpredictably.

  • On death, and potentially on disability, the affected co-owner’s share would need to be sold.

  • Without planning, you could end up with an unknown new co-owner or with your partner’s spouse or children working in the business.

  • A buy-and-sell agreement specifies how a co-owner’s share is to be distributed if they exit the business.

  • This avoids future disagreements and legal battles.

  • Life and disability cover can be added to the agreement, providing the means for the remaining co-owner/s to buy the deceased or disabled co-owner’s share of the business.

An unexpected illness or death can cause chaos for your business, particularly where there is more than one owner. You need to make sure that your business can continue to operate with minimal disruption.

A buy-and-sell agreement, combined with life insurance, will ensure the smooth transition of the business to the surviving or remaining co-owners.

Protecting a multi-owner business

A co-owner may leave of their own free will, such as to retire, but if they die or become disabled, there are serious consequences to consider.

  • A deceased co-owner’s share of the business forms part of their estate and may be sold to realise the value in the estate.

  • The other co-owners may not have the funds to buy this share of the business, so the executor of the estate may sell it to the highest bidder or pass it to the heirs, resulting in a person you do not know becoming your business partner.

  • The business may be forced to take out a bank loan to purchase the deceased co-owner’s share. The loan repayments will have a negative impact on business cash flow and may be unaffordable.

  • The co-owner’s family may have relied on the salary they drew from the business. This income will vanish overnight, and the deceased’s spouse may be forced to work in a business they don’t understand or care about just to make ends meet.

  • A deceased or disabled co-owner’s adult children may assume senior positions in the business, causing conflict and stress for the remaining co-owners.

All of this stress can be avoided by having a buy-and-sell agreement in place. A life insurance policy can be incorporated into the agreement to provide funds in the event of death or disability, allowing the remaining co-owners to buy the deceased or disabled owner’s share of the business.

A buy-and-sell agreement in action

A buy-and-sell agreement has two components: the contract and the insurance.

Firstly, the business is appraised, and a fair value is assigned to each co-owner’s share.

Then an attorney drafts an agreement that documents this value as well as what will happen if an owner exits the business, through death, disability or illness.

The agreement specifies how and when each party’s shares will be distributed, as well as who will control the business. This avoids future disagreements and legal battles.

In the agreement, each co-owner agrees to purchase life insurance on the lives of the other co-owners. Disability insurance can be included. The amount of cover is based on the business valuation and the percentage of each co-owner’s share. The policy will pay out if a co-owner dies or becomes disabled. Proceeds are used by the surviving co-owner/s to purchase their share of the business.

The finer details

If you own shares in a business in your own name, this will be included in your estate when you die and could make your estate liable for estate duty.  Read more: What is estate duty?

A life insurance policy that you take out on your own life is a deemed to be an asset in your estate when you die.  Read more: What is an estate?

If life insurance is taken out by your co-owners to buy your share of the business after your death, the value of the shares could be counted twice in your estate – once as the shares and once as the proceeds of the policy.

There is therefore an exemption for life insurance policies taken out for buy-and-sell agreements, as long as they meet certain requirements. One of these is that the premiums must all be paid by the co-owners from the inception of the policy. The policies must also be owned by the other co-owners. The premiums will not be tax deductible, but the payouts are tax-free and exempt from estate duty.

It is therefore best that the policy is taken out by your co-owners on your life.

Remember you can leave the shares in your business to your heirs in your will, but you cannot direct how the insurance in a buy-and-sell agreement is used in your will. This should be done in the buy-and-sell agreement and ownership of the policy.

A financial adviser can facilitate the discussion between you and your attorney to ensure that all of the necessary elements are in place.