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Buy-Sell Agreements: Why Every Partnership Needs One and Critical Provisions

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Buy-Sell Agreements: Why Every Partnership Needs One and Critical Provisions

Relationships take work and business partnerships are no different. Failing to plan for key life events such as death, disability, divorce, and departure of a partner can have serious negative impacts on your client's business and even put the survival of their business at risk. A properly drafted buy-sell agreement addresses all of these events and provides the company with a clear path forward in times of uncertainty and crisis.

Presenters

Len Garza
Principal
Garza Law

Transcript

- Hi, everyone. Welcome to today's CLE, I'm Len Garza, I'm founder and principal attorney at Garza Business and Estate Law. We're located in Princeton, New Jersey, but we have clients nationwide. And what we do at my firm is we represent family businesses, close corporations, business owners, executives, and private companies. And we help them get formed properly, structured properly, help them to grow in a healthy and sustainable way and help them plan for exit or the next generation. And that's what we're gonna be talking about today. We're gonna be talking about business owners and companies when they think of the future, what happens next? What are some things that could happen in the future that could greatly impact the business and how do we as a business and as a company, prepare for that and have contingency plans for that. So one of these events that comes up does not sync the company or otherwise negatively impact the people, the partners and, people who work here everybody's lives basically. So this is an important and critical issue to all businesses. And today we're really gonna be looking at it from the standpoint of typical family businesses, close corporations and businesses with a few owners, partnerships, things like that. So when we talk about this, we're looking at an agreement typically that looks at succession planning and things to do, and contingency planning for the business called a buy-sell agreement. Now, these type of agreements go through many names and we'll get into some of those different names, different terms, but for as an umbrella term, we're gonna be referring to 'em as a buy-sell agreement and buy-sell agreement, the name of this program is, buy-sell agreements, why every partnership needs one in critical provisions. It's important to note that for the most part, unless I specify otherwise in this program, that when I refer to a partnership business, company, corporation, LLC, I'm using those terms interchangeably, right? Unless I specify in the program that, these are certain rules that only apply to LLCs or partnerships or C corporation or S corporation, I'll specify that. But otherwise, if you hear me refer to one of those terms, it's interchangeable, with me using the term company, your business or corporation more generally. So as an initial matter, before we dive right into buy-sell agreements and terms, provisions that you want in there and different ways that certain language impacts those provisions, let's back up. And let's talk about why it's important to have a written agreement for your business in the first place. Now, depending on what your company is, if it's a C corporation, it could be everything from, you know, bylaws, founders, agreements, shareholder agreements, things like that, partnership agreement, it would be a partnership agreement or it's sometimes called buy-sell agreement. You know, these terms are interchangeable. A lot of the times, if it's an LLC, you'd be looking at at what's called an LLC operating agreement, the end result that we're looking at here is really the same with any of these. And it is to, why do we want these aside from just having the partners who are likely close, have a long business relationship, or maybe even a family relationship, why is it important to get their relationship in writing? Well, what you want is you want a legally binding document that stipulates how the business is to be governed. And when you sign an agreement, all the partners agree to abide by the document's terms. And what this does is this helps the company minimize problems and dispute. Disputes. Why is it important to have one? Why is it important to have this in writing rather than just go on oral or handshake agreement amongst the partners about how the business is gonna be run? Well, it's important that the partners decide how they run their business, not the state. So in the absence of a signed agreement, state laws which vary by state will be used to settle disputes within the company. So by necessity, when you have these state laws, they can't possibly take into account the uniqueness or idiosyncrasies of your business and your relationships. So by necessity there's, they are one size fits all rules. It's much better to have an agreement in which the firm's partners or the company's members state the rules for their company on their own terms, rather than being governed by a static state statute. Voting is another reason that it's important to have a written agreement amongst your owners. You  want to make sure that the voting rights accurately reflect the interests of your business. For example, one of my clients, a digital marketing agency has four partners and they came to me and they asked me to help them with their first ever partnership agreement. They'd been in business for a couple of years by that point. And they had not previously hired an attorney in forming their business. They'd gone through an online service and set up their company, the skeleton of their company with very loose skeleton documents there. And they were looking for an attorney to, help them polish those up and improve them and to fill any holes and also develop a partnership agreement for them. And so they came to me and the firm was dominated by its founder. After talking to them it became very clear that the firm had one founder and the other three partners had come along sometime after that founder and this founder brought in most of the company's clients, he managed the company and he was a primary driver for virtually everything in the firm. So he was primarily responsible for the agency's success and profits. Now without a written agreement. Well, first of all, it's very important that in the written agreement that that accurately memorialize the business' interests, their philosophies and their vision for the future for how they want to grow. So without a written agreement, the founder was susceptible to the other three partners, essentially throwing him out of the firm with, or without valid cause because the state laws for the particular state that we were dealing with held that in the absence of a written partnership agreement, all partners interests are treated equally and based on any capital that they'd input into the firm. And they'd roughly put in roughly the same amount of capital, the founder had put in a little bit more capital than the other three partners, but the founder had put in much more, as far as non-financial resources, as far as ideas, reputation, leadership overall manage of the business. And we wanted to make sure that that was accounted for within the voting allocation for the agency. So that's why it's critical for them to have a written agreement because otherwise you couldn't do that. So really a big reason, the critical reason to have a written agreement is it allows you to customize your relationship amongst the other partners and amongst the business to really do what suits you and the uniqueness of your company. And another way to do that aside from the voting rights. And what we've talked about earlier is allocating company income, right? So having a written agreement allows the business to customize allocation of the revenues and incomes fairly in accordance with performance of the partners. So for example, if a partner brings in a big client, the partnership can decide to give that partner a larger percentage of the income for that year, or make some other allocation that all partners think is appropriate. And they can agree upon that. If you don't have a written agreement where that's firmly in writing, then you're left to whatever the state statutes say for your organization. And they could have static rules that you and the partners don't agree on, or that you don't like. As another example of where the one size fits all state statutory model doesn't work. One of my clients was a partnership of five orthopedic surgeons. Now, four of the surgeons were in their 40's, in their prime, the primer, their careers, and the fifth partner was a surgeon. And he was in his late 60's. Now that partner in his 60's had been a mentor of sorts to two of the other partners earlier in their careers, but he was working less now. And he had planned to retire in the next few years, likely the next five years. So the younger partners, the way the business or the practice is currently set up, the younger partners would be doing all the business development and management of the practice. And those were, were substantial responsibilities for the practice. The senior partner would have no business development and no management duties. He... The role he played was much more of a senior sage, so to speak and someone to go to on certain specific issues. But he was not as involved day to day with the practice and especially not involved with business development and management of the practice as the younger partners. So for this partnership, we structure the organization and the agreement provisions to permit, pay allocation and voting, to coincide with the realities of the running the practice and have the voting and allocation of the revenue to be weighted heavier in favor of the younger partners versus the senior partner. Now under the state statute, this would not have been possible. This is not, this wouldn't have happened. All parties, would've had an equal share. This would've resulted in the senior partner having as much interest as the other more active partners, even though the senior partner was not near as active. So that would not have served any of the interests of the partners. None of them would've wanted that. And that clearly did not fit the realities of the practice. So we needed to account for that in the partnership agreement. And we did that. Another key reason that it's important to have a comprehensive written agreement amongst your partners, your members, or your managing shareholders are to specify circumstances that allow the company to expel a partner. Without a written agreement as to these terms, your company will be greatly limited in terminating partners, even for egregious acts. So it's very important that, that you outline that because state statutes, many state statutes don't provide for a clear and clean and orderly way to, for a partner to automatically not automatically, but for a partner to voluntarily withdraw from the partnership or for the other partners to expel that partner. And frequently the resolution to that is the statutes permit the partner to, or the partnership to resort to litigation, or they require them to file a court action to initiate this type of withdrawal. So that would not obviously fit the best interests of a lot of partnerships out there that are looking to do this type of thing in a, an orderly way, but don't want to go to court to do so. And these are just some of the key reasons that you want a written agreement governing the partnership corporation or the LLC. Other critical issues of these types of agreements that you need to address as far as governance are admitting new partners, admitting new members, what's the process for doing this. Expelling partners or members like we talked about before, what's the process for doing this? The timeframes, notice provisions, things like that. These are things you  want to lay out in the agreement. The duties of the partners. Can partners compete with a partnership, for example, can they have outside interests that either don't compete with a partnership or potentially can compete with a partnership? That's a key issue to address and management duties. Who manages the company? Are all decisions decided the same way? For example, submission to a board or shareholders for a majority vote, or are there some major decisions, for example, whether the company should merge or sale of the company. Are there some major decisions like that that rather than being decided by a majority vote should be decided by a higher approval vote, for example, super majority or potentially unanimous? These are all things governance issues that you  want to talk through as partners, or if your their council talk through with them to make sure that the agreement reflects the values in the various interests that they want to have in their company. When we think of buy-sell agreements and why a partnership or company might want to develop a buy-sell agreement, or why it would be of interest to them, clients, many times, they're not specifically asking for a buy-sell agreement. They may not even know what it is. More sophisticated clients might, but they may not even know what it is, but they do know about the four D'S or what the four D's are and that they can negatively impact the business. They may not fully appreciate... Many of them don't fully appreciate how these events can negatively impact the business. But that is where if you're representing 'em our responsibility as an attorney is to let them know and bring to their attention. the risks of all of these events characterized through the four D's, not only the risks, but how to plan for them. And the way you plan for them is through a number of ways, you know, in insurance, having the key conversations amongst the partners, but the way that's done eventually in the agreement is through the buy-sell agreement. So what are the four D's? Well, those are death, disability, divorce, and departure. And we'll break into each of those and how, some of the questions that arise for those that are important to the business, but the business needs to have a well conceived and designed buy-sell agreement that addresses each of these events. And with a proper plan in place, a company will suffer much less disruption and uncertainty when these disruptive events happen. So as it relates to death, key questions, a partner dies. What happens when the partner dies? Who gets that partner's shares or their interest in the company? I have an auto parts manufactured client that had three partners. One of them had a heart attack and died rather suddenly. They had a rather flimsy partnership agreement prior to them coming to me. And the agreement did not address death of a partner. Now, surviving partners thought the deceased partner shares would somehow automatically transfer to them upon the death of their partner. That is wrong. Quite frankly, they're incorrect. And they were quite surprised to learn that pursuant to their state law, the deceased partner share of the business, transferred to his wife. The wife knew nothing about the auto business and was not close with the partners. The... And what happened was the wife made life very difficult for the surviving partners and refused to sell her husband shares to them unless they paid, what we believed was an exorbitant price for those shares. Now the partner sought to pay the wife or her husband's interest, but they couldn't agree on a price. And so this dispute stretched on for months with the wife, making multiple threats to sue the surviving partners. This disruption distracted them from their business and caused them a lot of frustration and strife and likely caused them a number of sleepless nights, worrying about what would happen. And if they continue to keep their business afloat. Eventually the partners ended up having to borrow 250,000 to buy out the deceased partner's wife as a shareholder. That obligation resulted in the partnership, having significant unplanned financial impact on their bottom line, but they accomplished what they needed to. They got the deceased partner's wife outta the picture, and they're able to purchase back shares of their partnership. But this could have all been avoided by having provisions as to death of a partner in their partnership agreement. And because they didn't have those provisions and weren't prepared for it, their partnership is going to be dealing with the financial ramifications of that for quite a while. The next D, disability. What happens when a partner is disabled and is unable to work for a prolonged period of time? What does the business do, if the disabled partner is unlikely to come back to work, but refuses to sell the shares back to the non disabled partners? We'll go into greater detail about how to handle those issues and key questions. The next D, divorce. Many business owners are shocked to learn that in the absence of an agreement, addressing how divorce of a partner is handled upon a partner, getting divorced, that partner's ex-spouse can make a valid claim on his share of the business. In many states, the ex-spouse becomes the business partner through intestate or testamentary transfer upon death of the partner. Now that's when a partner dies. But in the event of a divorce, when a judge is looking at splitting up the assets equitably, one of the assets of the spouse is that spouse's business interest. So it will be key in those divorce proceedings what type of agreement, if any, governs that business interest. And if there's no agreement stating how that interest is handled, then the business interest or share is fair game to be split up and go to the ex-spouse. And the ex-spouse can make life very difficult for the business owners in purchasing the ex-spouse's shares The next D, departure. What happens if your partner wants to leave the partnership? If you're not prepared and your business is not set up properly, this could sync the partnership. You might have to dissolve the business. You need contingency plans set up. Again this is where having a skillfully written agreement is critical. Does the partner have the power to leave? Under what circumstances? Can the member simply withdraw? What happens to the value of her shares? Can she sell those shares to someone outside the company? Can she demand that the company buy them out from her? If she can demand a buyout, how much are the shares worth? Who decides what they're worth? This brings to mind a contentious litigation case I handled years ago, amongst five doctors that had partnered in multiple businesses. One of them was a clinical practice, and one of them was a real estate company and they had a few others. Now, the doctors had all formed together to form what they believed was a dream team of sorts. And it was, they were all very experienced, very accomplished doctors, and they all got along great at the very beginning until they didn't a few years later. The doctors started having disputes amongst themselves. One of the doctors had a heart attack and died. His wife inherited his shares and his role in the companies. And this exacerbated the difficulties that the doctors were having, because she was demanding a buyout of her husband's shares in the business, but the doctors didn't want to pay. One of the doctors, wanted to leave the partnership. This did not sit well with the other partners, the head partner, who was the doctor who wanted to leave. It was that doctor's mentor earlier in his career had wanted the doctor who wanted to depart to succeed him in his own practice. But now that that doctor wanted to leave and was choosing to go his own way. The head partner was very resentful of that and was determined to make life very difficult for that doctor in trying to leave the partnership. Now, these doctors had a partnership agreement in place, but the agreements were, but the agreement was vague on key issues. What was the value of the company? How's the value to be determined? The agreement was silent on these issues. How can a partner withdraw from the partnership? Silent there again. During the litigation, when we asked how the partner who wanted to depart it, how the partner who wanted to depart may be able to withdraw from the partnership. The head partner said, "the only way you can leave is through the grave." There was a lot of ego and drama in that case, but it's obvious that trying to negotiate these major issues between partners is much more difficult when tensions and emotions are high. The way to handle these important issues is to address them early on in the relationship, by addressing them in a comprehensive buy-sell agreement. Before you run into trouble. Regarding expulsion, you  want to make sure that the agreement has language and addresses voting out a partner. For example, if an LLC wants one member gone, the operating agreement might have a provision for voting that member out, whether she actually wants out or not. Some agreements may stipulate that the vote can occur at any time and for any reason, while other agreements may state that a member can only be voted out, if she's acting against the company's interests. Now, again, you can customize, you can and should customize this within the agreement, because if you leave it up to state law, many states say that when there's no written agreement as to this issue, state law typically has specific provisions for when members can remove other members or managers who broken the law or breach their duty or loyalty to the company. Outside of that, there may be limited or no option under your state statute for expelling a partner or a member. Now for dealing with death, I  want to back up and just reiterate that there's no one size fits all buy-sell agreement. The terms to include in a buy-sell agreement, depend on the owners and the company's unique circumstances. And there are a lot of variables here. So for example, how many owners are there? A buy-sell agreement that you'd prepare for two owners can be quite a bit different, if there are more than two owners or three owners or five owners. A lot of it may be the same, but you're definitely not gonna have the same, the exact same agreement between two, when you're dealing with a partnership or a company with two owners versus three or more, that would require more complexity. Are the owners all of a similar age, or do their ages span years maybe even decades? Are any of the partners nearing retirement age? These are just some of the important questions that depending on the answers, there's gonna be more of an emphasis on certain provisions, in certain areas, in the buy-sell agreement versus other areas. If you have all partners who are in their 30's or 40's, they may be a lot less concerned with what to do, if one of them dies or becomes disabled. But conversely, they're very concerned and focused on the provisions relating to if one of them departs and how to buy and force a buyback of shares. When we're dealing with death of a partner in a buy-sell agreement, you  want to be thinking about life insurance. Most companies that set up buy-sell agreements, they carry life insurance on the partners to pay out to the partners estate, if when that partner dies. Now purchasing life insurance, it's not required, but many, maybe even most companies do purchase it to help with paying out the deceased partner's interest so that the company doesn't get in a cash flow crunch due to the obligation to pay out the deceased partner's interest. In short life insurance provides liquidity at the death of an owner. A properly drafted buy-sell agreement on these points would memorialize one, the company's authority, or maybe even the obligation, depending on how the agreement's structured, the authority or obligation to purchase life insurance on each of the partners. And two, how that life insurance proceeds are to be used at the death of the owner. What are the ways to structure the redemption and cross purchase agreement? I'm sorry, strike the previous portion. What are the ways to structure the life insurance purchase and payout? Well, a couple ways you can do it are called the, make it a redemption or a cross purchase. So, or you could have a hybrid of the two. So if we go through an example, Jim, Pam and Dwight create a corporation and are the initial sole shareholders, what factors should they consider in structuring their buy-sell agreement? So if you look at a redemption agreement and you see this diagram here, at the death of an owner, the entity will be the buyer of the decedent's interests in the entity. Therefore the entity will own the life insurance policies ensuring the lives of its owners. At the owner's death, the proceeds are paid to the entity and the entity uses the proceeds to buy the interests of the deceased owner from her personal representative. Once the entity buys the shares, the shares are no longer outstanding in the interests of the remaining owners in the entity are increased proportionally. Proportionately. An advantage of structuring your buy-sell this way is that it's simple and provides for centralized management to administer the policies and collect the death benefits because the policies are owned by the entity. The policies are not subject to reach by each of the owners creditors or includible in the owner's estate, as they are with a cross purchase agreement, which we'll discuss shortly. Also, another benefit of structuring this as a redemption is if an owner leaves the business policies on the remaining owners would not be disrupted the way they would with a cross purchase agreement. Now with a cross purchase agreement, what is this? This is where the structure involves the surviving business owners, not the entity. to surviving business owners purchasing, or at least having the first option to purchase the deceased owners interest in the entity. The business owners individually own the policies ensuring each other's lives. The entity does not own these policies. When a business owner dies, the proceeds are paid to those surviving owners who hold one or more policies on the deceased owner and these surviving owners buy the shares from the deceased owners, personal representative. An advantage to structuring this as a cross purchase agreement is you get a tax advantage. So regarding the basis, any shares, the surviving owners buy from the deceased owner will get a step up in basis to what the surviving owners paid for the deceased owner shares. Thus, if these shares are later sold at an amount greater than their basis, the surviving owners will recognize lower capital gains tax than the other shares they hold. Structuring the life insurance in a cross purchase agreement also may avoid lender and creditor restrictions of the entity imposed on the entity's cash flow as sales of the ownership interest occur between the owners and do not involve the entity. In contrast with the redemption agreement, the entity owns and pays for all of the life insurance policy and as also the beneficiary of the policies. So in the above example, if Dwight dies, the life insurance proceeds are paid directly to the corporation, which then uses the funds to redeem the shares held by Dwight's personal representative. Jim and Pam would not be directly involved in the purchase. In contrast with a cross purchase agreement, Jim, Pam, and Dwight own policies on each other. And they each name the others of them as the beneficiaries. So if Dwight dies, Jim and Pam would receive the policy proceeds directly and they would individually purchase Dwight's shares from Dwight's personal representative, the corporation would not be involved. A significant downside of a cross purchase agreement is if the company has more than two partners buying and managing the life insurance policies gets administratively cumbersome. The complexity increases with the number of partners. The number of policies required under a cross purchase agreement will be higher than that for redemption agreement, if more than two owners are involved. So for example, if you have three owners, this a cross purchase agreement would require the purchase of six life insurance policies. If you add just one more owner, you have four owners, the cross purchase agreement would now require purchase of 12 policies. So as you can see, when you have two, maybe even three owners a cross purchase could be a really viable option for you. But anytime you get more than that, the administrative complexity of administering the life insurance policies is definitely a big thing to think about. Now you can blend the two plans or two approaches into a hybrid approach. And this is used where the owners want the flexibility for either the entity or the surviving owners to buy a deceased owner's interest. And it requires those receiving insurance proceeds at the death of the owner to be obligated, to purchase deceased owner's interest. To the extent all of the interest is not purchased with insurance. So in the example above, if the corporation receives insurance proceeds at Dwight's death, the corporation would first be required to purchase those shares with the value equal to the insurance proceeds received. Then the surviving owners will be obligated to purchase any shares left over after the insurance proceeds are exhausted. So in summary, we compare the redemption agreement to the cross purchase agreement. And when we compare them, we notice a few primary issues. With regard to the redemption agreement, the tax consequences are key to consider. If the entity is a C corporation, the corporation wants to distribute any excess life insurance policy proceeds to the remaining shareholders, those distributions could be treated as a taxable dividend to the remaining shareholders. You also need to be aware of with regard to redemption agreements, contract prohibitions. So what we're talking about here is even though the corporation collects the proceeds, different contracts that the prohibit or that the business may have with a lender or creditor, those agreements may have restrictions that preclude the corporation from how they used the proceeds and the corporation could be restricted or prohibited from using those proceeds to buy a deceased shareholder's shares. For instance, the corporation may have loan documents restricting its ability to use the corporation's resources to buy the shares. Tort creditors could present similar obstacles. In those circumstances, the other owners could purchase the interest, but the insurance proceeds would not be available for them to do so . With redemption agreements, there's also no step up in basis for the surviving owners because the company owns the policy and will receive the proceeds of the policy. Typically, the remaining owners will not receive a step up basis when the owner dies. This result would be different if the entity is for example, a cash method S corporation and the redemption is structured properly, or a partnership with special provisions, Cross purchase agreements also have issues that need to be considered. Is state tax inclusion and credit claims or potential risks with this type of agreement. The policies that an owner owns on the other owners will likely be includible  in the owner's estate. If an owner has creditor issues, including a divorce, the policies owned on the lives that the other owners might be subject to those creditors claims. And as we talked about previously, cross purchase agreements are also more complicated to administer than redemption agreements. Besides the multiplicity of policies, the entity needs to make sure that the policy owners, the owners of the business actually pay the required premiums. As the owners are likely to be of different ages and health. The costs of the various policies are likely to be different. Meaning the owners will owe differing amounts each year. This adds to the complexity. The entity may have to gross up distributions to the owners by different amounts to account for this, and to allow the owners to pay the policies. Cross purchase agreements for corporations, raise the issue of transfer for value. If a remaining shareholder purchases a policy from a deceased shareholder on the life of a third shareholder. And most cases, receipt of life insurance proceeds is not a taxable event. However, if a life insurance policy is transferred for a valuable consideration, the net proceeds of sale are treated as ordinary income when received. So a purchase of a deceased shareholder's interest in a policy on the life of a third shareholder might trigger income tax when that policy pays off. This would result in any proceeds, the remaining shareholder later receive an excess of the purchase price plus any premium he or she has paid since the purchase to be subject to income tax. If insurance is being relied on to fund a buy-sell agreement, the planning might implode due to high mortality expenses and an owner ages. If the cost isn't too expensive, the parties should consider buying permanent life insurance instead of term life insurance, where costs will be higher earlier with the permanent life insurance, but much lower in later years, as compared as compared to term insurance. You'll also need to make decisions for how long the policies should be made viable. Also, you'll  want to make sure you have a backup plan, if the insurance expires. Many agreements, provide for a payout over time of any portion of the purchase price, not covered by insurance. Also, it's important to remember with situations where the entity purchases the insurance in, for example, redemption agreements that the insurance premiums paid by an entity in connection with the buy-sell agreement are not deductible by the entity. This adds to the cost of the insurance and should be considered when structuring your agreement. One of the challenges with partners life insurance is making sure that the insurance tracks along with the company and is kept updated and not stale. You  want to make sure to increase the coverage from time to time and make sure that it's keeping pace with the growth of the partnership. Failure to keep the policy amounts current is one of the best examples of company to-dos that often fall through the cracks. It's easy for the company to forget, to make these updates. So disability. How do we deal with the disability of a partner or a member or major shareholder in the company? Many say that disability is harder to deal with as compared to death. And definitely that's true from a company governance standpoint. Death is clear and finite, but disability is much more complicated and unclear. Some of the relevant questions you ask in looking at how to plan for disability to a partner is what is the extent of the disability? What's the likelihood that the partner can fully recover from the disability? How long will that recovery take? When the partner does return to work, is he capable of performing normal partner duties and working normal partner hours? Let's focus on two, the two types of disability, temporary disability, and permanent disability . With temporary disability situations in which partners suffer a disability that prevents them from working as partners in the firm for a limited period of time, usually less than a year. That's what we mean typically by temporary disability and how we define it in the buy-sell agreement. Many temporarily disabled partners, hope to return full time. So an examples of temporary disability could be from a heart attack, serious automobile accident, or from surgery. In contrast permanent disability, these are situations in which partners suffer a disability that permanently prevents them from working as partners in the company. The vast majority of companies stipulate in their buy-sell agreements, that if the partner is unable to return to work within one year, they're declared permanently disabled and retired. Now similar to life insurance in planning for death, you have disability insurance. Some businesses carry partner, disability insurance, and many do not. This type of insurance is very expensive. And the prohibitive cost often persuades many companies to forego this type of insurance. Further, most disability policies cover only a fraction of the disabled partners compensation. For example, what I see is it's rare that a disability policy will come in to replace over 60% of a disabled partners compensation. Given these factors, I see many partnerships find this enough to persuade them that the high cost of this insurance just isn't worth it and they go without. In your agreement, it's very important when you're addressing disability to carefully define what disability means. One example of disability that I often see in these agreements that is workable is defining disability as the inability of a partner to conduct and carry on normal functions of responsibilities as a partner, that's important as a partner, not as a non-partner is some lesser role, and they have to be able to perform these duties during normal business days, Monday through Friday of each week, excluding holidays, Saturdays and Sundays on a full time basis due to physical or mental impairment. Now, this is a stricter definition of disability than you'll often find in disability insurance policies . For disability insurance policies, the definition depends on the particular company and the particular type of policy. So it varies from policy to policy, but a common definition, specifies, specific levels of disability that one needs to meet, to qualify for benefits. For example, partial disability, full disability. And with each of those definitions, the policy typically prescribes a percentage of the total disability benefit you can receive under that particular definition. A couple of examples for key definitions in disability policies would be own occupation versus any occupation. So in an own occupation definition, this provides that an individual is unable to perform normal functions and responsibilities of his occupation. This is less restrictive than the definition that we gave above that requires them to be able to perform the normal functions, responsibilities of a partner, not just of the occupation. And another definition, different definition would be rather than own occupation would be any occupation. Now, this is much broader. This provides that an individual is unable to perform normal functions and responsibilities in any occupation for which you are suited based on your education training and or experience. If the partner is still able to work at another job, even a simpler, lower paying job, that individual might not qualify for benefits under this policy definition of disability. In many cases, it's not clear when the newly disabled partner will be able to return to work . Until permanent disability is determined, there may be a period of time when the partner returns to work and then stops or works less than full time. You can use some of the following wording or similar to address this situation. For example, you could say something to the effect of the, in the agreement that permanent disability shall be declared, If the partners are off work for an aggregate period of 75 days, doesn't have to be consecutive 75 days during any 12 month period. And it's not required necessarily that it be within the same calendar year period. This language is subject to the condition that if such partners resume their normal partner duties for at least 25 hours during any week, then no portion of that week will be counted as one of the 75 days. So that's just some of the language that you can use and augment or modify to fit your specific purpose. It's also a good idea to implement language in the agreement that permanent disability shall be declared when there's no reasonable expectation of recovering from the illness or injury based on a written opinion of a physician. Another term that is good to include in this section of the agreement is that the term disability shall not automatically include the consequences of alcohol, drug or other substance abuse. A period of rehabilitation may be granted or withheld by the partners at their discretion. A partner may be granted a leave of absence without pay while actively pursuing rehabilitation and making satisfactory progress as determined to the satisfaction of the partners towards such rehabilitation. A partner disabled for one year will be deemed to have retired. During the period in which a partner is disabled, but not yet declared permanently disabled, we need a method of compensating the partner. I've seen a lot of rules and conventions adopted by a lot of different companies, but overall of them, these variables come up time and time again. You need to decide how long is full-time compensation paid? How long is any form of compensation paid? If you pay compensation, what percentage of full-time compensation should be paid? And regarding that, a few of the examples that I've seen are that the disabled partner gets paid full time for six months and then nothing thereafter. Another option is the disabled partner gets paid full-time for six months and then 50% of full-time salary for the following six months. And another option is a percentage of full-time pay. The partner receives a percentage of the full-time pay for the full 12 months. In other words, the partner once disabled does not receive full-time pay for any of the months, but merely a percentage for all 12 months. Another example that I've seen work well is something like this that the agreement provides during the disability period partners shall receive 100% of their normal compensation for the first three months of disability. For the next three months, they receive 75% of their normal compensation. For the next three months after that , they receive 50% of their normal compensation. And for the final three months of the disability year, they receive 25% of their normal compensation. All of these payments would be reduced by any disability payments made to the disabled partner. How do we deal with the final D? Departure or retirement of a partner. Members, shareholders, or partners depart from an established business. And when they do, they should have a clean exit. There should be a plan for this to avoid disruption and have minimal disturbance or distraction to the business. Whether a partner is leaving on their own or being bought out, the buy-sell agreement should clearly define the process for the buyout and the obligations of the departing partner, as well as the business. You should lay out the following clearly in the buy-sell agreement under departure. The final obligations of both the departing partner in the business, all monies to be paid when the monies are to be paid and consequences for failure to pay. For example, you can include a sample promissory note as an exhibit to the agreement. Generally, the more detailed you can make the timeframes and the procedures for departure, the better. For example, you want to include a clear and specific notice provision for departure. You want to have specific timeframes for all steps in the departure and buyout. You want to have specific language as to how we determine the value of the departing partner's interests. Don't leave these things to interpretation or later adjustment or negotiation. Establishing the fair market value of the business is a key starting point. A partner buyout can't be accurately or fairly executed without something that objectively assesses the tangible and intangible assets of the company . For that you need an independent business evaluation. And the subsequent distribution of equity to the selling partner can be a contentious topic that is hotly debated. Hiring a qualified business appraiser, a third party appraiser that the business owners jointly agree to using will greatly reduce differing opinions on value and keep things objective in the buyout negotiations. However, if the business is complex or if intangible value is a large factor in the business, or if partners are at odds, the owners may wish to hire their own business appraisal experts to conduct separate independent reviews. And these scenarios, the owners can then consider both conclusions of value and find common ground for the partnership buyout terms. We need to determine how the business partner exiting the business will be financially compensated and how that will be structured. Can the partnership make payment in one lump sum or over a period of time? Very rarely have I ever seen payment come in one lump sum more often than not payment is made in installments over a period of time. Whatever you do the goal here is to fairly compensate the exiting partner while not punishing the other partners or the business cash flows in a detrimental way. Should the company consider outside financing to finance the payout? The remaining partners may seek partner buyout financing options as a path forward if a lump sum or installment payments are not viable. The partnership agreement or buy-sell agreement should also address liability. What are the consequences for the partnership's failure to pay the departing partner the buyout? One way to handle this is to have the remaining members or shareholders pledge their member interest or shares as collateral for payment to the departing partner. You also  want to make sure as the departing partner that you get released and the partnership releases you from any future operations of the partnership. It's important to be removed from any financial obligations the company may owe to lenders, bonding companies, factors, mortgages, et cetera. So now that we've taken a, a high level overview of the four D's and ways to address them in the buy-sell agreement, what are some of the common mistakes I see made in buy-sell agreements? Well, in no particular order, a big one is failing to keep the agreement up to date. You need to look at the agreement periodically and look the attorney with the business and make sure that the terms are up to date and not stale. For example, are the members or partners the same or have partners been added or left? Has the management of the company changed? Has the company grown or retracted significantly? These things and other things can impact the owner's situation and future goals for the company. Does the agreement still align with those goals and company outlook? The partner's answers to these questions can change and impact many provisions in the partnership. For example, what is the method, the chosen method for determining the valuation of the business? Another issue I see quite frequently is that the agreement does not govern all assets that may be owned by the partners. For example, real estate is a common one. Oftentimes real estate is held outside of the operating company or partnership. Possibly is a different LLC or company altogether. With the agreements are drafted and the real estate isn't held by a party subject to the agreement, the real estate is also not subject to the terms of the buy-sell agreement. So you're gonna  want to make sure that if real estate's involved that the buy-sell agreement, if you intend for it to govern that real estate, that that's specifically stated within the agreement and if not, and the real estate is part of a separate company that you and the partners also are part of, make sure that you have terms that you all can agree on that address, how that real estate is handled. Another big mistake is that the buy-sell agreement is not funded or the funding isn't structured properly. So as we've discussed previously, a buy-sell agreement often requires a buy out of ownership, interest upon a certain triggering event, for example, death, disability, divorce, departure, but when no planning has been done by the business for how to fund the buyout problems do occur. When the event occurs, for example, death, disability, divorce, the four Ds, the company must determine how it will obtain the funds to meet the obligation. Oftentimes relying on current cash flow or borrowing funds. In the event of a death or disability, this can often be addressed with the purchasing an insurance policy. If the insurance is used, however, it's essential to ensure that the terms of the agreement match the terms of the insurance. All too often, the insurance is not owned by the right party or funded for the right amount, both of which can cause financial and tax issues. So in closing, when you're forming a partnership with someone or multiple people or any type of business venture, LLC, corporation, partnership, whatever the business entity is, defining that relationship and the parameters and the governance is critical to the long term success of that business venture. This can lead to some direct and often uncomfortable conversations with your partners, but you need to have these critical conversations. The best way to preempt or prompt these critical conversations and bring them to the table is through developing a partnership agreement or a buy-sell agreement. The process of creating this type of agreement should force you and your partners into having the candid discussions about which each of you, what you want from the relationship. The way a potential business partner reacts to the candor and direct questions will usually tell you all more than enough about what you need to know to be successful as a partnership. Thank you for joining us. I hope you've learned a lot about buy-sell agreements today. There's much more than I can possibly cover in one hour. And many of the subsets of things that we talked about can be covered or would need to be covered in more detail in many hours, long CLEs in and of themselves. So today was really just a high level overview regarding buy-sell agreements. And hopefully they've peaked your curiosity to do even more research or listen to more programming, to find out more about them if you want to handle these things for your clients. Here is my contact information. I hope you enjoyed the program. Please feel free to reach out to me anytime. Just mention that you saw my CLE here at Quimbee, and I'm happy to try to help you out or give you guidance anyway I can. Thank you very much.

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1h 3m 17s

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