Getting a Family Business Ready Before a Partner’s Potential Bankruptcy

The Situation

Sarah Whitfield is 26 years old and owns a one-third interest in a family-owned outdoor services company she runs alongside her parents, Mark and Diane, who each hold the remaining two-thirds in equal shares. The company is a Wyoming LLC registered and in good standing in California, taxed as an S corporation. It grew, in part, out of the client relationships of an earlier company Mark and Diane had previously operated, one that went through its own business bankruptcy the year before, with its equipment liquidated and the matter fully wound down.

Now a more personal financial crisis was approaching. Mark, and possibly Diane depending on how their community property and commingled finances worked out with their bankruptcy attorney, may file personal bankruptcy within the year. Sarah came to us wanting a Buy-Sell Agreement in place before that filing happened, not after.

Several other factors layered on top of the core problem:

• The company's existing Operating Agreement had never been tested against a scenario like this, and its actual transfer and buyout terms were unclear even to the family members who had reviewed it.
• Sarah was married and wanted any future claims from a divorce addressed, so the business couldn't end up split with a spouse who had never worked in it.
• Sarah anticipated her own role changing over time. She was building a separate business with her husband and expected to shift toward part-time, administrative work for the family company rather than continuing full-time field operations.
• Because the company was taxed as an S corporation, an incorrectly structured ownership transfer could inadvertently terminate that election entirely, turning a personal bankruptcy into a much larger tax problem for everyone involved.

Our Analysis

Making the Bankruptcy Filing Itself the Trigger

The first design decision was timing. If the triggering event were defined as something that happens after the bankruptcy filing (for example, a later court order), Mark and Diane would still technically retain their ownership interest and associated rights during the gap, exactly the period when a bankruptcy trustee has the most leverage. We structured the agreement so that the filing of the bankruptcy petition itself, immediately, is the triggering event.

From there, the transfer follows a set order. The company gets the first option to buy the departing owner's interest, and if the company declines, the remaining owners get a proportional option. We also discussed whether it made more sense for the company to buy the interest directly (an entity redemption) or for Sarah personally to buy it (a cross-purchase), and built in flexibility to decide that closer to the actual filing, since either can work depending on financing and tax considerations at the time. Whichever structure is used, the transaction must be conducted at arm's length. If it looks like value was moved out of the bankruptcy estate for less than it was worth, a trustee can challenge it regardless of how the paperwork is styled.

Preserving the S Corporation Election

Because the company is taxed as an S corporation, transfer restrictions had to do double duty. First to protect against the bankruptcy risk while also preventing any transfer that could accidentally violate S corporation eligibility rules (for example, a transfer to or through a shareholder who isn't a U.S. citizen or resident). We built those restrictions directly into the transfer mechanics described above, rather than treating S corporation compliance as a separate afterthought.

This same concern shaped how we approached valuation discounts, discussed next. Discounts applied inconsistently among owners can create the appearance of differing rights attached to the same class of stock, which risks the same S election. Depending on the specific facts, whatever discount methodology the family adopts may need to apply the same way to a comparable triggering event, regardless of which owner it happens to affect.

Building a Valuation Methodology That Could Hold Up to Bankruptcy Scrutiny

Given the bankruptcy, an arbitrary or low buyout number was not an option. Something like a flat $5,000 or $10,000 figure would likely draw immediate scrutiny from a trustee as an attempt to move value out of the estate. An earnings multiple, such as a multiple of EBITDA, was also a poor fit here. EBITDA is relatively easy to influence (for example, by adjusting W-2 salaries), which makes it a weak foundation to defend in a bankruptcy context.

Instead, we recommended a single, formal valuation from a CPA or appraiser accredited in business valuation, understanding that this typically runs around $5,000 – $10,000 in cost. Some Buy-Sell Agreements call for a cascading appraisal process (a second appraiser if the first is disputed, sometimes a third), but that can run the cost up substantially, and for this business, a single qualified appraisal paired with binding arbitration for any disagreement struck a better balance between defensibility and cost.

We also discussed the illustrative mechanics of valuation discounts using a hypothetical example. If the company were valued at $900,000, a one-third interest would be worth roughly $300,000 before adjustment. A combined discount for lack of control (a minority interest can't direct the company) and lack of marketability (there's no open market for shares in a private, family-owned business) can, depending on the facts and applicable law, run up to around 30% in some circumstances, which in this hypothetical would bring the payout to roughly $210,000. Whether a discount like that is appropriate, and at what percentage, depends heavily on the specific transaction and the law that applies to it, so this is exactly the kind of provision that needs case-specific legal judgment rather than a one-size-fits-all number. We discussed drafting the provision with a built-in ceiling (for example, a stated percentage or the maximum allowed under applicable law, whichever is less), which preserves flexibility while staying within legal limits.

Because family members did not all agree yet on whether a discount belonged in the agreement at all, we also discussed sequencing. The family could adopt a discount now, given the immediate bankruptcy timeline, and revisit or amend that provision later once the bankruptcy is behind them and the more pressing urgency has passed.

Structuring Flexible Triggering Events for a Family Business

Beyond bankruptcy, we walked through which other events should force a buyout, and, just as importantly, which shouldn't.

Included as triggers:

• Death of an owner
• Disability (generally defined by reference to a disability insurance policy, if one is in place)
• Voluntary resignation or a meaningful reduction in services, defined here as falling below five hours per week of W-2 work, a threshold designed specifically around Sarah's anticipated shift toward part-time administrative involvement as her husband's business grows
• Involuntary termination for cause (fraud, embezzlement, or serious misconduct), which in a family business needs a check like a majority vote among the other owners rather than a unilateral call
• Material breach of the agreement
• Criminal conduct that harms the company
• Filing a petition to dissolve the company

Left out, and why:

• Retirement, since the company is still young and a voluntary reduction in hours already covers that scenario
• Drag-along, tag-along, and lock-up provisions, common in agreements built around an eventual third-party sale, but a poor fit here since any future sale the family anticipates would likely be an all-or-nothing transaction rather than a partial one
• Lapses in professional licensing or certifications, since those tend to be administrative hiccups that are correctable rather than fundamental breakdowns in the ownership relationship

Additional Issues Addressed in the Same Engagement

If This Sounds Familiar

If a co-owner in your business is facing a potential bankruptcy, a divorce, or another major personal financial event, the timing of your planning matters as much as its substance. A Buy-Sell Agreement put in place after a bankruptcy filing is often too late to fully protect the company; a bankruptcy trustee has considerably more leverage once the filing has already happened. The same is true for family businesses more generally: agreements built while everyone is getting along are far easier to negotiate than agreements built under pressure once something has already gone wrong.