Partnership agreements are written documents that explicitly detail the relationship between the business partners, as well as their individual obligations and contributions to the partnership. Since partnership agreements should cover all possible business situations that could arise during the life of the partnership, the documents are often complex, and legal counsel in drafting and reviewing the finished contract is generally recommended. If a partnership does not have a partnership agreement in place when it dissolves, the guidelines of the Uniform Partnership Act and various state laws will determine how the assets and debts of the partnership are distributed.
THE BUY-SELL AGREEMENT The buy-sell agreement is one of the most important elements of any partnership agreement. It details what will happen to the partnership if one of its partners leave the business. In essence, it specifies the terms of a buyout in the event of death, divorce, disability, or retirement. "Having a buy/sell agreement in place makes a great deal of difference," commented Mary Rowland in Nation's Business, "to guarantee the smooth transition of a business and ensure that it need not be sold at an inopportune time." Indeed, the importance of this particular element of the partnership agreement is underlined by the fact that in recent years, loan institutions, companies that provide bonding for construction jobs, and other outside firms have begun to insist that small business clients have buy/sell agreements in place.
The two primary structures for buy/sell agreements are cross purchase agreements, in which the remaining partnership owners buy the departing partner's stock or partnership interest, and the stock redemption agreement, in which the company buys the stock of the departing owner. The advantage of the cross purchase agreement, wrote Rowland, is that "the purchasers get a tax saving 'step up' in basis to the market value of that portion of the business…. With a cross purchase agreement, the owners typically buy life insurance policies on one another to finance the agreement. If there are just two owners, it's pretty straightforward," but with multiple shareholders, this arrangement can get confusing and expensive.
With stock redemption agreements, on the other hand, "the company would own the life insurance policy and pay the premiums," said Rowland. "An advantage to this type of agreement is that if there are a number of owners, only one policy on each is necessary." Disadvantages of this type of buy/sell agreement include absence of 'step up' savings and the fact that in cases where the life insurance used to finance the redemption agreement is owned by a business structured as a C Corporation, the company might be liable for the alternative minimum tax (AMT) on any proceeds.
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Rowland, Mary. "The Importance of Buy/Sell Agreements." Nation's Business. March 1995.
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Williford, Jerry S., and Robin L. Imrie. "The Accountant's Role in Preparing and Amending Partnership or LLC Agreements." Journal of Partnership Taxation. Summer 1996.