You need a partnership agreement, limited liability agreement, or shareholder’s agreement depending on the type of business entity you have.
If you have a general partnership, or a limited partnership, there should be a partnership agreement that governs your business entity. The partnership agreement contains many provisions that help govern the business while you are alive, such as the percentage of equity each partner owns, the amount of income distributions, the proper tax treatment of the partnership, whether partnership interests can be transferred, the process for admitting new partners, and many other issues.
The partnership agreement also can (and should) have provisions on what will occur when a partner dies. In most cases, partnerships provide for the buy out of a partner’s share upon death because partners don’t necessarily want to be in business with someone’s family members. As a result, the buyout provisions can be detailed in the agreement.
The provisions should include a process for how the buy out will occur. For example, how will the partnership interest be valued? You can use a set amount or you can provide an appraisal procedure to be used. How will the buyout be paid? You can provide for a lump sum payment, or payments made over time. Can the partnership share be sold to a third-party? If so, who controls that sale of the partnership interest and to whom can it be sold?
These are just a few examples of issues to be covered by a well-drafted partnership agreement. Some partnership agreements are highly detailed and provide creative solutions to handling a deceased partner’s share of the business. These provisions protect both the surviving partners, and the family of the deceased partner by providing an orderly plan to buy out the deceased partners share of the business.
The same result can be accomplished with an LLC agreement or a shareholder’s agreement if your business entity is a corporation. While the agreement is a little different, the underlying practicality is the same—providing for an orderly buy out of a deceased business owner. The problem in most troubled cases is not the provisions that are drafted, but rather, the lack of a written instrument altogether. Without a written agreement, it can be difficult to determine what the decedent owned and how that interest should be bought out. And unfortunately, the decedent is not there to explain his or her understanding of the business arrangement.
Once you have the partnership agreement in place, you can then plan how the buy out will be funded. In many cases partners will buy life insurance on the life of each partner that will provide an insurance death benefit to the business upon a partner’s death. The business can then use the proceeds from the life insurance policy to fund the buy out of the deceased partner. This allows the deceased partner’s family to receive their fair share of the estate without placing an onerous financial burden on the business.
The bottom line: with a proper written agreement and some advance planning, you can make the buy out process fairly painless.