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Drop Dead Valuation – When an Owner Dies Without a Buy-Sell Agreement

August 6, 2015

The right thing to do is have a buy-sell agreement, but many owners stupidly neglect to get this done.  Here is a suggested buy-out plan where one owner drops dead, unexpectedly, and there is no agreement.

A caveat is that the right way is to engage an appraiser to determine the value and go through an entire process that was explained in my previous blog.  However, with smaller businesses where the families want to keep costs low, not cause excessive time and stress and remain friends… what follows is a suggested plan.  This might not work in every situation and is certainly not ideal.  However, it does offer a manageable method of price and terms.

Valuation Method #1:

    • The price for the deceased owner’s share of the business will be equal to two times the average salary and benefits paid to the deceased plus two times his proportionate share of the average retained profits over the last three calendar years
    • Payment will be paid monthly over five years
    • An example is the deceased’s salary and benefits plus his proportionate share of retained profits for each year for the previous full three years were $300,000, $250,000 and $200,000… averaging $250,000.  The price is two times that amount or $500,000
    • The payment will be $100,000 per year
    • Interest will be added at the applicable federal rate (“AFR”)
    • The payment will be treated as a capital gain to the recipient.  Note that this will not be deductible by the buyer.  Alternatively, depending on the nature of the business, the buyer can elect to treat part of the payment as for goodwill and amortize the total payment over 15 years
    • Upon signing the agreement, the ownership interest will be turned over to the buyer, but will be held in escrow pending full payment to the buyer
    • This company or remaining owners can be the purchasers at their option

Valuation Method #2:

    • The price will be the proportionate book value (on the accrual basis) if this results in a higher valuation
    • The valuation date will be the last day of the previous fiscal year
    • Payment will be monthly over sixty months with AFR interest

Valuation Method #3:

    • This becomes effective if the company is sold within two years after the agreement is executed
    • The seller will receive 80% of their proportionate interest of the sales price if that amount is greater than the price under this method; and payment will be made in full at closing regardless of how payment is made by the ultimate buyer
    • There will be a reduction for principal payments previously made

Owner Loans:

    • Any owner loans will be treated separately and repaid over five years with interest at the AFR
    • The estate will agree to subordinate this amount to any bank debt for which the deceased was a personal guarantor as long as the estate is released from the guarantee
    • If there was no personal guarantee or no release, then no subordination

Other Issues:

  • All passwords, websites, social media sites, intangibles and any other property of the business will be retained by the company
  • If there is any IRS challenge to the valuation amount, each party will deal with it themselves or at their cost.  Regardless of what the IRS’ final determination is, this price will not change.

The above sets forth a workable plan if the two parties agree to it.  A reality test is to determine whether the survivor can handle the payments without undue stress.  I believe this is a reasonable method for a smaller business in that it gets it done quickly, without consternation and a minimal amount of legal and professional fees.  For larger businesses where the costs are relatively insignificant to the total transaction, this will not work.

Nothing is perfect but this plan can work well in the right circumstance.  It is a practical compromise and a get-it-done plan.  If the owners cared, they would have had an agreement and this plan wouldn’t be necessary.  Get it done right if you can or, if too late, do it this way and let the families get on with their lives.

If nothing is agreed to, there are a few alternatives.  Except for Alternative 1, the others do not seem reasonable.

Alternatives if Nothing is Done:

  • Alternative 1: Nothing has to be done.  The estate can remain an owner.  The surviving owner likely will have to account for his actions, but the business will still be intact and since he will be running it, he should have a greater element of control and would still earn his living
  • Alternative 2: The estate can look to sell their interest to a third party and then see if the survivor could match or exceed it
  • Alternative 3: The business could be sold intact to a third party
  • Alternative 4: The business could be liquidated

Keep in mind, if the owners cared, they would have had an agreement and none of this would be necessary.  The best thing to do is to not make a bad situation worse.  I believe that getting something done is better than the alternatives presented.

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