Buy-Sell Agreements for California Business Owners

Every company with more than one owner already has a plan for what happens when one of them leaves. If the owners never wrote it down, the plan is whatever the law, an estate, a divorce court or a creditor decides. A buy-sell agreement replaces that with terms the owners chose while they were all still at the table: who may buy, when, at what price, and with what money.

It can be a standalone contract, a section of a corporation's shareholder agreement, or part of an LLC's operating agreement. The form matters less than the four questions it answers.

1. Which events trigger it

A complete agreement names each event and says what happens next. The common ones:

• Death. The shares pass to the owner's estate or trust, often to a spouse or children who may not want, or be suited, to run the business.
• Disability. An owner who cannot work still owns a share, and the agreement should define disability and say when a buyout starts.
• Retirement or departure. A voluntary exit, sometimes with different terms for leaving early, being terminated, or going to a competitor.
• Divorce. In California, a spouse may hold a community property interest in shares acquired during the marriage, which is why the spouse's consent belongs in the agreement.
• Creditors and bankruptcy. A purchase right that keeps an owner's share from ending up with a creditor.
• Deadlock. A way out when two equal owners can no longer agree.

2. Who buys: the company or the other owners

In a redemption agreement, the company buys the departing owner's share. In a cross-purchase agreement, the remaining owners buy it personally. Some agreements combine the two, giving one side the first option and the other a backup.

The choice has tax consequences that changed in 2024. In Connelly v. United States, the Supreme Court held that “a corporation's contractual obligation to redeem shares is not necessarily a liability that reduces a corporation's value for purposes of the federal estate tax.” In that case, life insurance the company owned to fund a redemption increased the value of the deceased owner's shares for estate tax purposes, and the obligation to buy them back did not offset it. For owners with larger estates, that can make a company-owned policy raise the very tax it was bought to help pay. Our page on why company-owned life insurance can raise the estate tax walks through the arithmetic and the alternatives.

3. How the price is set

Agreements usually use one of three methods: a fixed price the owners update on a schedule, a formula such as a multiple of earnings or book value, or an appraisal by an independent valuation professional at the time of the event. A fixed price is simple and goes stale quickly; agreements that rely on one should say what happens when the owners have not updated it.

For family companies, the price also has to hold up for federal transfer tax. Under Internal Revenue Code section 2703, a price set by an agreement is disregarded in valuing the shares for estate and gift tax unless the agreement is a bona fide business arrangement, is not a device to transfer the shares to family members for less than full value, and has terms comparable to similar arm's length arrangements. An agreement that sets a low price among relatives can bind the family while the IRS values the shares at full market value anyway.

4. Where the money comes from

A buyout the buyer cannot pay for is a promise, not a plan. The usual sources:

• Life insurance for the death trigger, owned by the company or by the other owners, depending on the structure chosen above.
• Disability buyout insurance for the disability trigger.
• Installment payments over a set number of years, with interest and security for the seller.
• Company reserves set aside for the purpose.

Most agreements combine them: insurance for death, installments for retirement, and a cap on how much cash the company has to pay out in any one year so a buyout does not starve the business.

The California details that get missed

The owner's spouse. Under California Family Code section 760, property acquired during marriage by a married person domiciled in California is generally community property. Shares acquired during the marriage may be partly the spouse's, so the spouse should sign a consent agreeing that the buy-sell terms bind their interest too. Our page on who owns the business when it was built during the marriage covers the rest.

The owner's living trust. Most owners hold their shares in a revocable living trust, which is right for their estate plan. The agreement should allow transfers into each owner's trust without triggering a buyout, and say clearly that the trustee steps into the owner's place after death.

S corporations. An S corporation can have only eligible shareholders. If a buyout, a transfer to an heir, or a trust that does not qualify puts shares in the wrong hands, the election can end. Our page on why a living trust can end an S corporation election explains the trust side, and the buy-sell agreement should block any transfer that would break the election.

LLCs. In an LLC the buy-sell terms usually live in the operating agreement, and they should match how the LLC is taxed and how its members are actually paid.

When to revisit it

A buy-sell agreement is a snapshot of the company on the day it was signed. Review it when the company's value changes significantly, when an owner marries, divorces or has a child who may join the business, when insurance is bought, changed or lapses, when an owner's estate plan changes, and at least every few years even when nothing seems to have changed. The most common problem we see is not a bad agreement but a good one with a price nobody has updated in ten years.

How we help

Donald W. Flaig drafts buy-sell agreements for California corporations and LLCs, reviews existing ones, and makes sure each owner's living trust and the company's documents agree with each other. Because he also writes the owners' estate plans, he can see both sides of the same transfer: what the company needs on the day an owner leaves, and what the owner's family needs on the same day. See estate planning and business law for how the two fit. The first conversation is free.

This article is general information, not legal advice, and does not create an attorney-client relationship. Estate and business law change often and depend on your specific situation. Speak with Donald W. Flaig before acting.