Operating Agreements and Estate Planning: What to Include
Many LLC owners create an operating agreement without considering how it fits into their estate plan. But when an LLC owner passes away or becomes...
8 min read
Many business owners assume that when they pass away, their family members or business partners will seamlessly inherit their ownership stake. However, without a buy-sell agreement, business transitions can become legally complicated, financially burdensome, or even lead to the forced sale of the company.
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A buy-sell agreement ensures that ownership transfers smoothly in the event of death, incapacity, or an owner’s departure. This legally binding contract prevents probate delays, reduces the risk of disputes, and provides a clear path for business continuity—all while protecting the financial interests of heirs and surviving business partners.
This guide explains how a buy-sell agreement fits into an estate plan and why it is one of the most important tools for business owners who want to protect their legacy.
1. What Is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract that outlines what happens to a business owner’s interest if they pass away, become incapacitated, retire, or decide to leave the business. It ensures a structured ownership transfer by specifying:
- Who is allowed to buy the deceased owner’s shares.
- How the business will be valued.
- How the buyout will be funded.
Without a buy-sell agreement, an owner’s shares may become part of their personal estate, requiring probate before any transfer can occur. This can create legal delays, financial strain, and even conflicts between heirs and surviving business partners.
Why Every Business Needs a Buy-Sell Agreement
A buy-sell agreement is especially crucial for:
- LLCs, partnerships, and closely held corporations where ownership is shared among multiple individuals.
- Family businesses that want to prevent outside heirs from gaining control.
- Businesses with multiple owners who want to establish a smooth exit strategy in case of death, retirement, or disputes.
Example – How One Business Survived a Founder’s Death with a Buy-Sell Agreement
Sarah and Mark co-owned a manufacturing LLC. When Mark unexpectedly passed away, his family assumed they would inherit his 50% ownership. However, because Sarah and Mark had a buy-sell agreement in place, the business was protected. The agreement required Mark’s estate to sell his shares to Sarah at a pre-agreed price, which was funded through a life insurance policy.
This allowed Sarah to retain full control of the business while Mark’s family received a fair payout. Without a buy-sell agreement, the company could have ended up in a lengthy probate battle, jeopardizing its future.
2. How Buy-Sell Agreements Prevent Probate Delays
When a business owner passes away without a buy-sell agreement, their ownership interest becomes part of their personal estate, meaning it must go through probate before heirs or business partners can access it. This process can take months—or even years—leaving the business in limbo.
Why Probate Can Disrupt Business Operations
Without a clear ownership transfer plan, probate can:
- Freeze the business’s bank accounts until the court determines ownership.
- Prevent important business decisions from being made, leading to financial instability.
- Create conflicts between heirs and surviving business partners over who has the right to control or sell the business.
- Expose the business to creditors who may claim a share of the deceased owner’s interest.
A buy-sell agreement eliminates these risks by setting clear rules for what happens to a deceased owner’s shares. Instead of waiting for probate court to distribute assets, ownership transfers immediately and smoothly according to the agreement’s terms.
How a Buy-Sell Agreement Bypasses Probate
A properly structured buy-sell agreement removes the deceased’s ownership interest from their personal estate, ensuring it does not get tangled in probate. This is typically done by:
- Naming a designated buyer (such as a business partner or key employee) who has the first right to purchase the shares.
- Setting a pre-agreed valuation method to determine the buyout price fairly.
- Establishing a funding mechanism (such as life insurance or installment payments) to provide liquidity for the purchase.
By structuring the ownership transfer outside of probate, a buy-sell agreement preserves business continuity and prevents legal delays.
Pro Tip – The Most Common Mistake That Causes Business Ownership to Get Stuck in Probate
Many business owners assume that simply naming a successor in their will is enough to transfer their business. However, a will does not override state probate laws—meaning heirs may still face long legal battles before taking control. A buy-sell agreement is the only way to guarantee an immediate, probate-free transfer of business ownership.
3. Funding the Buyout: Life Insurance and Other Strategies
A buy-sell agreement is only effective if there is a solid financial plan to fund the buyout when an owner passes away. Without proper funding, surviving business partners or heirs may struggle to come up with the necessary cash, potentially forcing a sale or liquidation of the business. To avoid this, business owners should establish a clear funding strategy within the agreement.
Using Life Insurance to Fund a Buy-Sell Agreement
One of the most common and effective ways to fund a buy-sell agreement is life insurance. Each business owner takes out a life insurance policy on the other owners, ensuring that in the event of death, the payout provides the funds necessary to buy the deceased owner’s shares. This method guarantees:
- Immediate liquidity for the buyout.
- A smooth transition of ownership without financial strain.
- Protection for the deceased owner’s heirs, ensuring they receive fair compensation for the business interest.
For example, in a cross-purchase agreement, each owner owns a policy on the other. If one dies, the remaining owner(s) receive the payout and use it to buy out the deceased’s share. In an entity-purchase agreement, the business itself takes out the policies and uses the funds to redeem the deceased’s ownership stake.
Installment Payments for Gradual Buyouts
If life insurance is not an option, a buyout can be structured through installment payments, where the business or surviving owners purchase the deceased’s shares over time. This approach allows for flexibility but carries some risks, especially if the business struggles financially after the owner’s death. Without immediate liquidity, the process may take years to finalize, leaving heirs waiting for their full compensation.
Sinking Fund Approach
Another strategy is to create a sinking fund, where the business sets aside profits specifically for future buyouts. This proactive method ensures that when an owner departs, there are sufficient reserves to execute the agreement without disruption. However, it requires long-term financial discipline and may not provide enough coverage for an unexpected death or departure.
Example – How a Life Insurance-Funded Buyout Saved a Family Business from Closure
David and his brother ran a successful construction firm. They had a buy-sell agreement but knew that if one of them passed away, the surviving brother would need substantial funds to buy out the other’s share. To solve this, they took out life insurance policies on each other. When David unexpectedly passed away, his brother used the insurance payout to purchase David’s stake, ensuring that the business remained operational. Without this funding mechanism, David’s family might have been forced to sell the company just to receive their share of the estate.
4. Types of Buy-Sell Agreements and Which One to Use
Not all buy-sell agreements are structured the same way. The best type depends on the business structure, number of owners, and financial goals. Choosing the right one ensures a smooth transition and financial stability for both the business and heirs.
Cross-Purchase Agreements: Best for Small Partnerships
A cross-purchase agreement is common among businesses with two or a few owners. Each owner agrees to buy the shares of a deceased owner, usually using life insurance to fund the purchase.
This structure ensures that ownership stays with the remaining business partners rather than passing to an heir who may not be involved in the business. It also offers a tax advantage, as the surviving owners receive a stepped-up basis in the purchased shares, potentially reducing capital gains taxes if they sell later.
However, this approach can become complicated if there are multiple owners because each must maintain separate life insurance policies for the others, increasing administrative costs.
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Entity-Purchase Agreements: Ideal for Multi-Owner Businesses
In an entity-purchase agreement, the business itself is responsible for buying back the deceased owner’s shares. Instead of individual partners owning life insurance policies on each other, the business purchases a policy on each owner and uses the payout to buy their stake upon death.
This method simplifies ownership transfer, particularly for LLCs and corporations with multiple owners, because it centralizes the buyout process within the company. However, there can be tax implications, as the remaining owners do not receive a stepped-up basis in the acquired shares.
Hybrid Agreements: Combining Flexibility and Simplicity
A hybrid buy-sell agreement combines elements of both cross-purchase and entity-purchase agreements. Initially, the business has the first right to purchase the deceased owner’s shares. If it declines, the remaining owners have the option to buy them.
This approach provides more flexibility, allowing businesses to assess their financial situation before committing to a buyout while still giving partners a clear path to ownership.
Which Buy-Sell Agreement Is Best for Your Business?
Choosing the right buy-sell agreement depends on several factors:
- For businesses with only two or three owners, a cross-purchase agreement often works best.
- For larger companies, an entity-purchase agreement simplifies the process.
- For businesses needing flexibility, a hybrid agreement allows multiple options for funding the buyout.
Pro Tip – Which Buy-Sell Agreement Works Best for LLCs vs. Corporations?
LLCs often prefer entity-purchase agreements because they allow the company itself to handle ownership transfers. Corporations, especially those with many shareholders, may benefit more from hybrid agreements that allow both company and shareholder buyouts.
5. How to Integrate a Buy-Sell Agreement Into Your Estate Plan
A buy-sell agreement is only effective if it is properly aligned with the rest of your estate plan. Without integration, conflicts may arise between your will, trust, and business agreements, creating legal delays and financial complications for your heirs and business partners.
Aligning Your Buy-Sell Agreement with Wills and Trusts
Your will or trust should mirror the terms of your buy-sell agreement, ensuring that your business interest is transferred according to the contract’s terms. If a will or trust contradicts the buy-sell agreement—such as leaving LLC shares to an heir when the agreement requires them to be sold—it can lead to probate disputes and delays.
Example
If your buy-sell agreement states that your ownership share must be sold to your business partner, but your will gives that share to your child, courts may have to intervene to resolve the conflict. To avoid this, ensure your estate planning documents clearly reflect the buy-sell agreement’s terms.
Updating Your Buy-Sell Agreement as Your Business Grows
A buy-sell agreement is not a one-time document—it should be updated regularly to reflect:
- Changes in business valuation
- New business partners or investors
- Evolving tax laws that impact estate planning
- Your retirement or exit strategy
Failing to update your agreement can leave loopholes that complicate business transfers when the time comes.
Working with an Estate Planning Attorney
Because buy-sell agreements impact both business law and estate planning, it’s essential to work with professionals who understand both areas. An attorney can ensure:
- The agreement is legally sound and enforceable in your state.
- It is properly integrated into your will or trust.
- It follows current tax laws, minimizing financial risks for your heirs and business.
Example – The Business Owner Who Avoided an Ownership Dispute by Updating Their Buy-Sell Agreement
Alex and Chris started a tech company with an early buy-sell agreement stating that if one of them died, their shares would be sold to the surviving partner. Years later, Chris got married and updated his estate plan to leave his business shares to his spouse, but he never updated the buy-sell agreement. When Chris passed away, his widow claimed ownership, while Alex insisted on buying out the shares per their original agreement. This legal battle could have been avoided if Chris had updated his buy-sell agreement to match his estate plan.
Conclusion
A buy-sell agreement is one of the most important estate planning tools for business owners. Without one, an owner’s death or departure could result in probate delays, legal disputes, and financial instability for heirs and surviving partners.
By integrating a buy-sell agreement into your estate plan, you:
- Ensure a seamless transfer of business ownership.
- Protect heirs and partners from legal complications.
- Establish a fair buyout process with proper funding.
- Avoid probate and keep business operations running smoothly.
Now is the time to act—review your estate plan, update your buy-sell agreement, and work with an attorney to secure your business’s future.
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