If you own a closely held business, you’re probably familiar with the protections provided by buy-sell agreements. But do you know how important these documents can be to an estate plan? Because buy-sell agreements specify whether, and under what circumstances, owners’ interests may be transferred, they can help you control the ultimate disposition of your business and achieve other important estate and succession planning goals.

Reducing Disputes and Other Benefits

A well-crafted buy-sell agreement helps minimize the possibility of ownership and succession disputes and enables you to pass your business to family members or another select group — for example, management partners or other people actively involved in the enterprise. In addition, these agreements can provide you and your heirs or successors with liquidity to pay estate taxes and other expenses in the event you die or become disabled. Also, they generally establish the value of the business for gift and estate tax purposes (so long as certain requirements are met).

Typically, buy-sell agreements achieve all of these objectives by requiring or permitting the business or the remaining owners to purchase the interest of an owner who dies, becomes disabled or leaves the business. They may also provide the company or the remaining owners with a right of first refusal in the event you wish to sell your interest.

Getting Valuation Right

Buy-sell agreements should be planned and drafted carefully to ensure they meet your expectations and don’t trigger unwanted financial consequences or intrafamily conflicts after you’re gone. One of the most important provisions of any agreement is how the business should be valued.

Many agreements set the price using a formula tied to earnings, cash flow, book value or some other objective measure. Although formulas offer simplicity and lower costs, they can’t account for subjective characteristics or other factors that drive business value. As a result, they often underestimate or overestimate business value, which can lead to disputes when the buy-sell agreement is invoked.

The fairest and most effective method of setting the purchase price is to conduct periodic independent business valuations and to base the price on fair market value. Make sure you work with valuation professionals who have experience with your industry and businesses of your size.

Minimizing Taxes

Taxes are another potentially tricky issue. Generally, buy-sell agreements are structured either as “redemption” agreements or “cross-purchase” agreements. The former permit or require the company to purchase a departing owner’s shares, while the latter confer that right or obligation on the remaining owners.

From a tax perspective, cross-purchase agreements are generally preferable. The remaining owners receive the equivalent of a “stepped-up basis” in the purchased shares. This means that their basis for those shares will be determined by the price paid, which is the current fair market value. Having the higher basis will reduce their capital gains if they sell their interests down the road. Also, if the remaining owners fund the purchase with life insurance, the insurance proceeds are generally tax free.

The disadvantage of a cross-purchase agreement is that the owners, rather than the business, are responsible for funding the purchase of a departing owner’s interest. And if they use life insurance as a funding source, each owner will need to maintain insurance policies on the life of each of the other shareholders — a potentially cumbersome and expensive arrangement.

As for redemption agreements, they can trigger a variety of unwanted tax consequences. These include corporate alternative minimum tax, accumulated earnings tax or treatment of the purchase price as a taxable dividend.

Making Your Agreement Estate-Plan Friendly

When drafting a buy-sell agreement, words should be carefully chosen to ensure that it fulfills your objectives. Before signing, test it to see how it’ll perform under various scenarios, including your death. If your estate planning advisor isn’t already involved in the process, ask him or her to review your buy-sell agreement and suggest any changes that might make passing the business to your heirs easier or more tax efficient.