For construction businesses with more than one owner, continuity might seem to depend solely on keeping backlog strong and current jobs on schedule. But sudden ownership changes can disrupt operations just as much as bad weather or a major equipment breakdown. That’s why a well-designed and regularly updated buy-sell agreement is a must.

A legal matter

A “buy-sell” (as it’s often called for short) is a formal legal contract among a business’s owners that sets terms for the transfer of ownership interests. It gives owners, or the business itself, the right — or even the responsibility — to buy an exiting owner’s interest following a triggering event. Such events may include an owner’s voluntary departure, loss of a required professional license or certification, divorce, disability, retirement, or death.

Essentially, the agreement creates a market for a withdrawing owner’s interest. And by outlining when and to whom interests can be sold, it can help prevent conflicts among remaining owners or with the departing owner’s family. A buy-sell also addresses how the price of the interest will be determined, including defining the valuation method and standard of value to be used.

Use of life insurance

Life insurance is used to fund many agreements. When an owner dies, the right coverage can help ensure that the owner’s beneficiaries receive the agreed-upon price for the ownership interest in a timely manner. In addition, life insurance can ease the strain on the business’s cash flow, reducing the likelihood that it will have to sell assets to pay for the buyout. There are two primary ways of setting up a buy-sell with life insurance:

1. A cross-purchase agreement. Here, each owner takes out a policy on each of the other owners. In the simplest terms, let’s say your construction business is a two-person partnership. You’d buy a policy on your partner and vice versa. Should either of you die, the buy-sell would be triggered, and the surviving owner would collect the policy’s death benefit to buy the deceased partner’s ownership interest from his or her estate.

Assuming your policy remains in force and is large enough, it increases the likelihood that you’ll be able to fulfill your obligations under the agreement. In addition, with proper planning, death benefit proceeds are generally excluded from taxable income, and your tax basis in your newly acquired interests will be equal to the purchase price.

But a cross-purchase agreement can be cumbersome when there are multiple owners because of the number of policies required. It can also be unfair if there’s a significant disparity in owners’ ages or health, leading to substantial variations in policy premiums.

2. A redemption agreement. Under this approach, the business buys the departing owner’s interest, with the entity often having a first right or obligation to purchase before the interest can be transferred to a nonowner. Because the business buys the life insurance, only one policy per owner is needed. Death benefit proceeds are generally excluded from the business’s taxable income.

One disadvantage of a redemption agreement is that the remaining owners won’t receive a “step-up” in basis when the business buys the deceased owner’s interest. This can result in higher capital gains taxes when owners sell their interests.

For triggering events other than death, funding may come from disability buyout insurance, cash reserves, installment payments, seller or bank financing, or some combination thereof. This is why your agreement should specify not only the purchase price, but also how and when that price will be paid.

Get in the habit

If your construction business has more than one owner and hasn’t yet established a buy-sell, strongly consider doing so. It’s a critical risk-management measure. In the event you have one, review it regularly with your legal, tax and financial advisors every two to three years, or whenever a potential ownership change arises, to ensure it still reflects the realities of your business.

For more information about buy-sell agreements, read: Buy-Sells for Builders: Review Your Valuation Provision

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