Is Your Buy Sell Agreement Mandatory or Optional?

Is your buy sell agreement mandatory or optional? The answer matters because the two work very differently on the day an owner dies. A mandatory agreement requires the estate to hand over the shares and requires someone to buy them at the agreed price. An optional one only gives the buyer a choice, and for estate tax purposes an obligation can help fix the value of the business while a bare option generally will not.

Is Your Buy Sell Agreement Mandatory or Optional?

Most owners remember signing a buy-sell agreement. Few remember whether it says the company or the partners shall buy the shares or may buy them. That single verb is the whole difference.

What a Mandatory Agreement Does

A mandatory agreement is an obligation on both sides. When the triggering event happens, the buyer has to purchase and the owner or the owner's estate has to transfer the shares, at the price the agreement sets. Nobody gets to wait and see whether the deal still looks good.

What an Optional Agreement Does

An optional agreement gives the buyer a right to purchase without a duty to do so. Language like "shall have the option" or "may purchase" is the usual sign. The buyer can walk away, and the family may be left holding shares in a business they never planned to run.

Optional clauses are not always a mistake. Some owners want flexibility on a retirement or a lifetime departure. The trouble starts when the death provision is optional and nobody noticed.

Why the Word Matters for Estate Tax

When an owner dies, the estate reports what the business interest was worth. Many owners assume the price in their buy-sell agreement settles that number. It may, but only if the agreement meets certain conditions.

According to the Treasury regulation on valuing closely held stock, an agreement price is more likely to be respected when four things are true:

• The price is fixed or can be worked out from a formula or method written into the agreement.
• The estate is required to go through with the transfer at death.
• The owner could not freely transfer the shares to an outsider during life at some other price.
• The arrangement serves a real business purpose and is not a way to pass shares to family for less than they are worth.

The second item is where optional agreements run into trouble. If the buyer only has an option, the estate is not required to transfer anything at the agreed price, and the agreement may not fix the value at all. The business could then be valued at what it is actually worth, which may be far above the number in the document. The estate could pay tax on more than it received.

Family businesses face one more screen. Under Section 2703 of the tax code, an agreement among relatives is generally expected to be a genuine arrangement with terms comparable to what unrelated parties would agree to. A formal appraisal when the price is first set, plus regular updates, helps show that.

The decision matters most for owners whose estates may be large enough to owe federal or state estate tax. Your attorney and CPA decide how these rules apply to your entity and your estate. What we can say is that the verb in the agreement belongs on the list of questions you bring them.

Wait-and-See Is Not the Same as Optional

This is where the vocabulary gets confusing. A wait-and-see agreement is sometimes described as an optional buy-sell, and the description is a little misleading.

Here is a typical sequence. When an owner dies, the company gets a window of time to buy the shares. If it declines, the surviving owners get their own window. If they decline too, the company must buy. The options are sequencing devices stacked on top of a purchase that somebody is ultimately required to complete.

The version to worry about has no backstop. It lists who may buy and then stops. If every option lapses, the family is left with the shares and the agreement has not bound anyone. When you read your own document, look for the last paragraph in the sequence and see whether it says "shall."

Five Questions to Ask About Your Own Agreement

You do not need a law degree to read your agreement with a pencil. Mark each answer, and bring the page to your attorney.

1. Shall or may? Check the death provision first. If the word is "may" or "option," flag it.
2. Is there a backstop? If the agreement uses a wait-and-see order, confirm the sequence ends with a required purchase.
3. Is the price fixed or determinable? A dollar figure set a decade ago, or a clause that says "fair value" with no method, can cause the same kind of trouble. Our guide to valuing a business for a buy-sell agreement walks through the three common approaches.
4. Are lifetime transfers restricted? An agreement that lets an owner transfer shares to anyone during life looks different to the IRS than one that holds the shares to the agreed price.
5. Does the insurance match the obligation? A required purchase with no money behind it is a promise the business may not be able to keep.

That last question is the one we help with most. The 2022 MassMutual Business Owner Perspectives Study found that only about one-third of business owners have a buy-sell agreement in place, and that of those who do, over half may not be properly funded. A mandatory agreement raises the stakes on funding, because the buyer has to find the money.

Where Insurance Fits In

Once the obligation is in place, life insurance is the usual way to fund it. The policy owner should generally match the structure of the agreement, and the owner of the policy should also be the beneficiary. Mismatches here are a common finding when we look at existing arrangements. Our overview of buy-sell agreement funding with life insurance covers the main designs.

If your agreement has the company buy the shares, the Supreme Court Connelly decision is a second reason to have your attorney look at it. And if it has been a few years since anyone opened the document, the buy-sell agreement review checklist gives you a structured way to start.

The division of labor is simple. Your attorney drafts or amends the agreement. Your CPA confirms the tax treatment. We design and place the coverage so the money is there when the agreement calls for it. You can see how we approach this on our business owner strategies page, and the whole life insurance overview explains one of the policy types owners often use for funding.

If you are not sure which kind of agreement you have, schedule a conversation and bring a copy. We will read it with you and help you build the list of questions for your attorney.