Buy-Sell Agreements for the Closely Held Business
I. INTRODUCTION
A. Definition.
1. A buy-sell agreement is an agreement among the owners of the business and the entity.
2. The buy-sell agreement usually provides for the purchase and sale of ownership interests in the business at a price determined in accordance with the agreement, upon the occurrence of certain (usually future) events.
3. The events often include death, disability, bankruptcy or insolvency, and an attempted transfer to an outsider.
4. The events may also include divorce, and/or separation from service or termination of employment.
5. Many of the considerations are the same, whether the business operates as a corporation (a C corporation or an S corporation), or as a partnership or limited liability company.
B. Current Events Affecting Buy-Sell Agreements.
1. Partnerships and S corporations have been used increasingly in recent years.
2. Since the repeal of the General Utilities doctrine, gain on liquidation and/or redemptions or ownership interests in C corporations may be subject to two levels of income taxation, one at the corporate level and one at the shareholder level.
3. LLC acts have now been enacted in all 50 states and the District of Columbia.
4. Impact of the “check the box” rules.
5. Consider the effects of Internal Revenue Code Section 2703, which was added to the tax law in 1990. This section sets forth certain requirements that must be satisfied in order for the price established under a buy-sell agreement to be accepted for federal estate tax purposes.
II. PURPOSES OF A BUY-SELL AGREEMENT
A. For the Entity.
1. Provide for continuity of ownership and management.
2. Restrict the sale or transfer of ownership interests to (possibly) unwanted third parties.
3. Avoid transfers that could terminate an S election, the status of the corporation as a professional corporation under state law, or the termination of a partnership for tax purposes.
4. Enable a smooth transition in the control and/or ownership of the entity.
5. Provide a method of funding the buy-out of a withdrawing or deceased owner’s interest and establish the terms for the payment of the purchase price.
B. For the Withdrawing or Deceased Owner.
1. Provide a market for an otherwise unmarketable asset.
2. Ensure that the withdrawing or deceased owner or estate receives fair market value for the withdrawing or deceased owner’s investment or business interest.
3. Provide a source of financial support.
4. Provide liquidity for the withdrawing or deceased owner’s estate.
5. Protect the withdrawing or deceased owner from having to negotiate price and terms from a weak bargaining position.
6. Establish the value of the ownership interest for federal estate tax purposes.
7. Relieve the estate, distributees or beneficiaries from involvement in the affairs of the business, such as guaranteeing loans to the entity.
8. Provide for expeditious administration of a deceased owner’s estate by determining the price and terms in advance.
9. Minimize the risk of disputes with the spouse, children and other heirs of a deceased owner.
C. For the Retired or Disabled Owner.
1. Provide a source of cash, either in a lump sum or over a period of time.
2. More likely to obtain capital gain treatment.
a. Lower tax rate on capital gains for property held for more than 12 months is 15% (after May 5, 2003), as opposed to a 35% maximum rate on ordinary income.
b. Taxpayers who are individuals may use capital losses in excess of capital gains to offset only $3,000 of ordinary income each year.
c. In a capital transaction, the seller is taxed on the amount by which the amount realized on the sale exceeds adjusted tax basis.
d. Installment sale treatment is not available for certain transactions that are not treated as sales or exchanges, such as dividend distributions.
3. Reduce the potential for conflict between the disabled or retired owner and remaining owners over management and policy. Consider issues such as cash distributions, salaries, borrowings, and investment/diversification.
D. For the Continuing Owners.1. Provide certainty concerning the terms on which a retired, withdrawing or deceased or disabled owner’s equity interest will be purchased.
2. Provide a source of long-term financing for the purchase of a departing owner’s equity interest, possibly allowing installment payments to be made out of cash flow.
3. Avoid legal and practical considerations that may follow from negotiating price and terms with the family of a departing owner.
4. Minimize potential for conflicts between active owners and inactive or passive owners.
5. Provide a degree of protection from unfair competition.
III. PLANNING CONSIDERATIONS
A. Factors to Consider.
1. The type of entity; i.e., C corporation, S corporation, partnership, LLC or other.
2. The size of the entity, in volume of business, number of employees, assets, etc.
3. The value of the entity as a going concern.
4. The value, book value or liquidation value of the underlying assets.
5. The relative percentage or other ownership interests of the owners.
6. The ages and health of the equity owners.
7. Financial condition and liquidity of the owners.
8. General health of the owners.
9. Ability of the owners to obtain life insurance in adequate amounts, at acceptable premiums, and otherwise on acceptable terms and conditions.
10. The commitment of owners to the business and importance of their participation in the business.
11. Legal considerations that could impact the ability of a corporation to make dividend distributions or redeem stock.
12. Provisions of loan agreements and similar documents that affect the entity’s capital structure or financial ratios.
13. Family relationships between the owners.
14. The status of the working relationships between the owners.
15. Multigenerational planning for the business; the extent to which current ownership intends to remain active in the business.
16. Licensing and other legal or qualification requirements.
B. Types of Buy-Sell Agreements.
1. Cross Purchase Agreement.
2. Redemption Agreement.
3. Hybrid or Combination Agreement. Entity’s option or obligation to purchase can be assigned to the remaining owners.
a. Hybrid agreement may require the remaining owners to purchase any equity interest that is not purchased by the entity, because of legal considerations or insufficient funds or access to credit.
b. A C corporation should have the initial obligation to purchase the shares under a hybrid agreement.
C. Selecting the Form of Agreement.
1. Number of owners.
2. Premium payments on life insurance policies used to finance the purchase.
a. Premiums are not tax deductible.
b. Consider relative tax brackets of entity and individual owners
c. Considerations related to type of entity.
d. Insurability and cost of premiums for owners. Perceived inequities due to ages and health of owners.
3. Transfer-for-value problems.
a. Generally, life insurance death benefit proceeds are not subject to income tax unless the transfer-for-value rules apply.
b. If the transfer-for-value rules apply, the death benefit proceeds are taxable only to the extent they exceed the purchase price and post-transfer premiums paid by the transferee.
c. The transfer-for-value rule does not apply to a transfer to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or shareholder.
d. Consider policies owned by deceased stockholder in a cross purchase agreement.
e. Use partnership among the stockholders to avoid transfer for value problems. Consider even if partnership is newly created.
f. If a trust owns the policies pursuant to a cross-purchase agreement, the transfer-for-value rule may apply at the death of a shareholder when each of the remaining shareholders (as a beneficiary of the trust) obtains an increased interest in the remaining policies, presumably in exchange for the obligation to continue paying premiums. However, consider the exception for beneficiaries who are also partners in a partnership.
4. Alternative minimum tax problems.
a. Exception to AMT for a corporation with average annual gross receipts for the prior three years do not exceed $7,500,000.
b. After 1989, 75% of adjusted current earnings in excess of base alternative minimum taxable income is an adjustment in arriving at alternative minimum taxable income for C corporations. Adjusted current earnings include life insurance proceeds to the extent they exceed the corporation’s adjusted basis in the contract.
c. S corporation, partnership or LLC avoids this issue.
d. The increase in the cash value of a policy, to the extent the increase exceeds the premiums paid, is also included in adjusted current earnings. I
e. The corporate alternative minimum tax problem can be dealt with in three ways:
(1) The corporation can buy more insurance to pay the tax;
(2) Convert the corporation into an S corporation; or
(3) Utilize a cross-purchase agreement.
5. Accumulated earnings tax.
a. A C corporation may have accumulated earnings tax consequences if it sets aside liquid assets to fund the purchase of shares under a buy-sell agreement.
b. The accumulated earnings tax is equal to the highest tax rate on dividends, multiplied by the accumulated taxable income of a C corporation.
c. Generally, accumulated earnings are earnings and profits of the corporation in excess of the amount required for operating the business. A corporation is generally entitled to accumulate $250,000 without showing that the accumulation is necessary for the needs of the business. A personal service corporation is limited to $150,000.
d. Accumulating funds for the buy-out of a minority shareholder may be considered a reasonable need of the corporation.
e. The reasonable needs of the business include any amount accumulated during the taxable year of a stockholder’s death to redeem shares under Section 303.
6. Credit considerations.
a. Credit considerations may dictate whether the entity or the owners should have the primary obligation to purchase the interest of the withdrawing or deceased owner.
b. The entity may be prevented by restrictive covenants in loan agreements from redeeming its own shares or partnership interests.
c. The obligation to redeem the interest of a deceased owner may affect the entity’s ability to borrow in the future.
d. The choice may depend upon the relative financial condition of the entity and the owners.
e. Consider the rights of creditors to insurance proceeds.
7. Capital gain treatment.
a. The family attribution rules may characterize a corporation’s redemption of shares as essentially equivalent to a dividend.
b. A cross-purchase agreement may be necessary in a family corporation.
c. Consider eligibility for sale or exchange treatment under Section 303 of the Internal Revenue Code, to the extent of federal and state estate and death taxes and funeral and administration expenses, regardless of attribution rules.
d. Sale to another stockholder will nearly always be a capital gain transaction.
8. State law.
a. State law may restrict the ability of a corporation to redeem its shares.
b. A redemption agreement may resolve this problem in a number of ways.
9. Basis for income tax purposes.
a. Under a redemption agreement for a C corporation, the basis of the shares owned by the remaining shareholders is not increased as a result of the corporation’s purchase of the shares of the withdrawing or deceased shareholder.
b. On the other hand, a cross purchase agreement enables the remaining stockholders to obtain a basis in the newly purchased shares in the amount of the purchase price.
c. This issue is not relevant in the case of an S corporation, partnership or LLC since the remaining shareholders, partners, or members will receive an increase in the basis of their ownership interests regardless of the type of buy-sell arrangement used.
10. Deductibility of interest.
a. Investment interest limitations applicable to individuals (and partnerships, LLCs and S corporations).
b. If a C corporation is redeeming a shareholder’s shares, the interest is more likely to be deductible, since general limitations on the deductibility of interest apply only to individuals.
c. In the case of an S corporation, partnership or LLC, interest paid by owners will be classified as either deductible business interest, investment interest, or passive interest, depending on the involvement of the owner in the business, the amount of passive income, and the assets of the entity.
11. Other issues.
a. Under a cross-purchase agreement for a C corporation, the remaining shareholders may receive tax free proceeds from life insurance policies used to fund the purchase in excess of the required purchase price, which if received by the corporation under a redemption agreement would be trapped in the corporation and would be difficult to distribute to the shareholders without being treated as a dividend if the corporation had earnings and profits.
b. If a redemption agreement grants the entity the option to purchase an owner’s interest, the agreement should be drafted to exclude the withdrawing owner or the estate of a deceased owner from participating in the entity’s decision concerning the exercise of the option.
c. If some of the interests are held by members of the same family, special provisions may be required to ensure that the family group retains the same ownership percentage.
(1) For example, if husband and wife each own 25% of the interest in the entity, the agreement may give the survivor the right to purchase the interest of the first spouse to die before the entity or other owners have a right or obligation to purchase the interest.
D. Suggested Terms of a Buy-Sell Agreement.
1. Invoking events.
a. May include death, retirement or disability of an owner.
b. Often includes an attempted sale or other transfer to a third party.
c. Consider including termination or employment or other separation from service.
d. Consider adding divorce to the list of invoking events.
e. Events can be voluntary or involuntary.
f. Consider loss of professional liecnese.
g. Definition of disability.
h. The reason for the invoking event may affect the purchase price or terms.
i. Bankruptcy or insolvency of an owner. Note: This can avoid participation by a bankruptcy trustee in management. However, the purchase price must reflect the fair market value of the equity interest.
2. Determining the purchase price.
a. Fixed price.
(1) Possibly redetermined periodically by the owners.
(2) Consider using some other method to determine the price if the fixed price has not been redetermined within a specified period.
(3) Possible conflict between younger (healthier) owners and older owners who may be in bad health.
(4) Consider requiring automatic adjustment in purchase price.
b. Book value and adjusted book value.
(1) Will usually not reflect the fair market value of the business.
(2) Can use adjusted book value, to take into account:
(a) Assets that may not appear on the balance sheet, such as goodwill and work in progress.
(b) Any accrued income or expenses if accounting records are kept using cash accounting.
(c) Contingent liabilities;
(d) Appraised value of some assets, such as real estate and marketable securities.
(e) The loss of the deceased owner’s services to the business; and
(g) Insurance proceeds.
c. Appraisal.
(1) The agreement may require an appraisal at the time the equity interest of the withdrawing or deceased owner is to be purchased.
(2) The agreement may contain specific instructions on the factors to be considered and their relative weights.
(3) The cost and practical value of the appraisal.
(4) The method by which appraisers are selected.
(5) Any requirements concerning the qualification, experience and credentials of the appraiser.
d. Capitalization of earnings.
(1) Formula price based on the capitalization of average earnings over a specified number of years.
(2) Relative weight to earnings; i.e., more weight to earnings in more recent years.
(3) The capitalization rate should be set forth in the agreement or should be based on some objective standard.
(4) Consider definitions of earnings, particularly in the case of closely held C corporations.
e. Other valuation methods.
(1) Put and take method.
(2) Another method bases the purchase price on the estate tax value of the deceased owner’s interest.
(3) Percentage of gross receipts or other objective factors.
(4) Value determined based upon sales of equity ownership interests of comparable companies.
(5) Value based upon a pro rata share of the proceeds of a forced sale of the entity’s assets unless the remaining owners and the withdrawing owner or deceased owner’s estate can agree on another price.
(6) “Blend” of several of the above valuation methods.
3. Determining the Payment terms.
a. The buy-sell agreement should specify how the purchase price will be paid.
b. Most buy-sell agreements will permit a portion of the purchase price to be paid in installments, with the seller holding installment notes of the entity or continuing owners.
c. The purchase price also may be paid over a period of time based on the profitability of the entity.
d. Consider use of a private annuity to pay for the interest of the withdrawing owner when all the owners are related or objects of one another’s bounty. Note: A private annuity can result in significant estate tax savings if the annuitant dies prematurely.
e. The entity may use property to pay for the interest, including real property that the entity currently uses in the business.
(1) The selling owner would then lease the property back to the entity.
(2) However, a corporation will recognize gain on any appreciation in the property as a result of the exchange of the property for its own shares. This gain will be measured as of the date of the exchange.
f. Preferred stock or other securities of a corporation may be exchanged for the common stock of the corporation. Consider effect of applicable securities laws.
g. The entity may redeem a portion of the equity ownership interests each year over a period of years.
4. Mandatory or optional.
a. A decision should be made whether the purchase or sale will be mandatory, or whether the entity or remaining owners will instead have an option or right of first refusal.
b. Estate tax consequences.
(1) The estate tax consequences to the deceased owner’s estate must be considered if the entity or other owners have only a right of first refusal and the price at which the interest will be purchased is to be the higher of the price established under the agreement or the price contained in a good-faith offer from a third party.
(2) In such a situation, the purchase price established under the agreement is not likely to be accepted by the IRS for estate tax valuation purposes, because the actual price paid for the interest could be higher.
(3) However, if the entity or remaining owners have the right or obligation to purchase the interest at a price no higher than the price determined under the agreement, the buy-sell agreement should establish the estate tax value of the interest.
(4) Consider the effect if the entity or remaining owners are not obligated to purchase the interest.
5. Restrictions.
a. The buy-sell agreement usually should contain restrictions on owners’ voluntary transfers of interests in the business.
b. Transfers may be permitted to an owner’s spouse or children, or to trusts created for their benefit, in order to allow the owners to engage in estate planning transactions.
c. Transfers to third parties may be permitted after first offering the interest to the entity or the other owners, either at the price determined under the agreement or at the lower of the price determined under the agreement or the price offered by a third party.
E. Funding the Buy-Sell Agreement.
1. Life and disability insurance.
2. Other funding methods.
a. Sinking fund.
b. Use borrowed money.
IV. ESTABLISHING THE VALUE FOR ESTATE TAX PURPOSES
A. Fixing Purchase Price. Under the regulations and the case law, the purchase price determined under a buy-sell agreement can fix the value of an interest in a closely held business if the following four requirements are satisfied:
1. The price must either be fixed or determinable pursuant to a formula contained in the agreement.
2. The decedent’s estate must be obligated to sell at death at the fixed price.
3. The transfer restriction must apply during the deceased owner’s lifetime.
4. The agreement must be a bona fide business arrangement and not a device to pass the interest to the natural objects of the deceased owner’s bounty without full and adequate consideration in money or money’s worth.
5. Courts have held that “the reasonableness of the price set forth in a restrictive agreement should be evaluated based on the facts in existence at the date the agreement is reached unless intervening circumstances occur.”
6. In addition, intent to use the agreement as a testamentary disposition must usually be present before the agreement is held invalid.
B. Artificially Low Price. The owners may be tempted to set an artificially low price in the buy-sell agreement in an attempt to reduce the federal estate tax of a deceased owner, especially when the owners are related.
1. Internal Revenue Code Section 2703 should preclude related parties from depressing the value of an interest in a family-controlled entity through buy-sell agreements.
2. In the case of unrelated owners, the difference between the price of the interest under the agreement and the fair market value of the interest can be made up through the use of group term life insurance under I.R.C. § 79, split-dollar insurance arrangements, and death benefit only plans.
3. Consider irrevocable life insurance trusts.
4. Artificially low price may not qualify as a bona fide business agreement.