Effective Buy-Sell Agreements Article

Privately held businesses with multiple owners present unique organizational and managerial challenges. Partners do not always agree on the business direction. Circumstances change, and people can change over the years. While most businesses wind down at some point, they are designed to be perpetual. The ownership change is inevitable as people retire, become disabled, or die. Businesses need rules to define how the change will be governed.

The term for these contractual arrangements is buy-sell agreements. In a perfect world, a business consisting of multiple partners will establish a buy-sell agreement prior to establishing the business. Many businesses are short on capital when they begin. Buy-sell agreements can require extensive tax and legal work. Insurance policies need funding. Trusts may need to be established. The costs can be significant. But without the agreement, the costs of a disputed business separation can be enough to destroy a business.

The time to create a buy-sell agreement is as quickly as the company can afford one. The longer an organization waits, the greater the chances that circumstances will have begun to change. Preparing for change is always easiest when change is not on the immediate horizon. This article will identify the most popular buy-sell arrangements, discuss tax implications, and list the advantages and disadvantages of each option.

The content of this article sources from Steve Goodman’s 2014 book Business Succession Planning.Mr. Goodman, CPA is a Long Island, NY based estate planning professional with 25 years of family wealth and business succession planning experience.

Business Succession Planning

Business owners need to plan for the succession of their business. There are several events beyond the business owner’s control that may derail even the best thought-out succession plan. Fortunately, there are ways for a business owner to avoid the negative impact of many of these events by implementing a contingency plan that includes what is often referred to as a “buy-sell” agreement.

A buy-sell agreement is a binding contract between the co-owners of business about the future ownership and operation of the business. A proper buy-sell agreement will address such matters as the mechanisms for each coowner’s transfer of his or her equity interest in the company (1) voluntarily; (2) involuntarily upon such coowner’s death, disability, divorce, retirement, bankruptcy, or court judgment; (3) upon a termination of employment for cause and not for cause; and (4) in the event of a deadlock between the owners. Such mechanisms will establish specific guidelines with respect to the timing and manner of transfer (including the rights of each co-owner with respect to such transfer), valuation of the equity interests, terms of any transfer (i.e., terms of a sale), and the source of funds or manner of payment.

A thorough buy-sell agreement may also address important employment-related issues, such as the implementation of restrictive covenants that will limit a current or departing owner’s ability to engage in other ventures that may compete with the company (i.e., a non-compete agreement).

Basic Structure of Buy‑Sell Agreements

Entity Purchase Agreement

The corporation agrees with the shareholders that upon death, disability, or retirement of each, the stock will be purchased by the corporation at an agreed-upon price. The business entity purchases life insurance policies covering each owner. The business entity names itself as beneficiary. Upon the death of an owner, the death proceeds are paid out to the business. The business uses the proceeds to redeem the interests of the deceased owner. The deceased owner’s estate or heirs receive cash and the surviving owners have their ownership interests increased proportionally.

Advantages of Stock Redemption Form of Buy‑Sell Agreement

• only need one policy per shareholder
• no transfer-for-value problems (death benefits remain tax-free)
• corporate-owned policies carry cash value on books

Disadvantages of Stock Redemption Form of Buy‑Sell Agreement

• no increase in basis for surviving shareholder
• if family members are involved, IRC section 318 creates special tax problems—when a business is owned by family members, the redemption of a deceased owner’s business interest by the business entity may receive ordinary income tax treatment instead of the preferred exchange (capital gains tax) treatment. (Pertains to C Corps only)

Planning Notes for S Corporations

With proper utilization of a 1377 election, the surviving shareholders can receive an increase in basis. Family attribution rules do not apply to S corporations.

Cross‑Purchase Agreement

Each shareholder agrees that upon the death, disability, or retirement of each, the remaining shareholders will purchase the stock of the deceased, disabled, or retired owner at an agreed-upon price. Each individual owner purchases life insurance policies covering the lives of each of the other owners. Each owner then names himself as the beneficiary of the policies. Upon the death of an owner, each policy covering the deceased owner’s life pays out tax-free death proceeds. The surviving owners use the death proceeds to fulfill their obligation under the agreement to purchase the deceased owner’s business interest from the estate or heirs.

Advantages of Cross‑Purchase form of Buy‑Sell Agreement

• purchasing owners receive a full increase in basis
• no corporate accounting necessary and no charge to earnings in the early years
• no application of family attribution rules of IRC section 318 (Pertains to C- Corps only.

Disadvantages of Cross‑Purchase form of Buy‑Sell Agreement

• need for multiple policies—a number of policies = n x (n-1), where n is the number of owners; example: cross-purchase agreement on five owners requires twenty life insurance policies (5 x (5-1))
• death benefits may become taxable due to transfer-for-value rules; IRC section 101(b) causes the death benefits of a life insurance policy to be taxable when a life insurance contract or any interest therein is transferred (by assignment or otherwise) for valuable consideration

Trusted Buy‑Sell

In a trusted buy-sell agreement, the owners of business enter a contractual agreement that places restrictions on the ownership of their business interests. The agreement will typically state what is to occur upon various triggering events, such as death, disability, termination of employment (voluntary or involuntary), insolvency of an owner, divorce of an owner, etc. Trusted buy-sell agreements are generally set up as cross-purchase agreements and require that the business owners purchase the business interests of an owner when a triggering event occurs. For example, the agreement would require that the owners purchase the business interests of a deceased shareholder. The business owners establish a trust that will be the owner and beneficiary of life insurance policies covering the lives of the owners (one per owner). The trustee will be responsible for carrying out the terms of the trust when a death occurs.

The trusted buy-sell agreement solves the multiple policy issues that arise with cross-purchase agreements. However, with a trusted buy-sell agreement that uses life insurance to fund the buyout, many tax advisors feel that the death of a business owner will create what is referred to as a transfer-for-value issue (TFV).

TFV results in the death benefit being taxable to the recipient, which would substantially diminish the amount received.There are numerous exceptions to the transfer-for-value rules that are beyond the scope of this discussion, but if TFV is a concern with your tax advisors, you may want to consider a general partnership buy-sell agreement (discussed below).

General Partnership (or LLC) Buy‑Sell Agreement

The owners of the business form a partnership or LLC taxed as a partnership.(It may be possible to use a preexisting entity.)A provision allowing for a special allocation of life insurance death benefits should be included.Each business owner will own an interest in the partnership in proportion to their interests in the corporation.The partnership will purchase one policy on each business owner.Premiums are paid with contributions from the owner s.They may take taxable distributions from the business to pay premiums.

If an owner dies prior to retirement, the partnership receives the insurance policy proceeds and distributes to the surviving owners who purchase the stock of the departing owner. At retirement, the life insurance policies may be distributed to each insured who may draw on the policy cash values to supplement retirement income.

A general partnership buy-sell agreement has several advantages:

• May be accomplished with one policy per member/partner.
• Family attribution rules of IRC section 318 do not apply to an LLC taxed as a partnership.
• Survivors receive an increase in basis.
• No transfer-for-value concerns.
• Retirement payments. When a member redeems his entire interest, the buy-sell may be set up so payments are tax free up to basis then taxed as capital gains (IRC section 736(b) and section 731).
• The life insurance death proceeds will be outside each member’s gross estate for estate tax purposes, as long as the proceeds are payable to the LLC. (Rev. Ruling 83–147).Proportional fair-market value of the LLC would be included in the estate.
• Flexibility of LLC allows for changes in the agreement for new owners.

Note for S corporations: One of the most common questions I am asked is whether a business should implement a simple entity purchase agreement or a cross-purchase agreement. Since many closely held businesses are S corporations, the answer from a tax perspective is that it really doesn’t matter. The big disadvantage most advisors point to in an entity agreement is that upon the death of a shareholder, the surviving shareholders will not get an increase in basis. For cash basis S corporations, there is a way around this called the 1377 (short tax year) election. The steps that are typically taken in order to increase the basis of the surviving shareholders by making the short tax year election are as follows (assuming three shareholders):

1. The corporation buys (redeems) the shares from the executor of the deceased shareholder. The corporation issues a short-term interest-bearing note to the executor, in exchange for the deceased shareholder’s stock. At this point, there are only two remaining shareholders, plus one creditor. The important part here is that the estate is not a shareholder; it is a creditor.
2. The surviving stockholders plus the executor of the deceased shareholder file, on behalf of the corporation, an election to terminate the tax year of the S corp. This is permitted under section 1377 (a)(2) of the code.
3. The S corp. files a death claim with the insurance company.
4. The insurance proceeds are received by the S corporation and increase the basis of the surviving shareholders. In this case, there is a 50/50 split, since there are two equal shareholders. If the insurance had been received by the corporation prior to the shares being redeemed, the basis would have been allocated to three shareholder: the two survivors and the estate.
5. The proceeds are paid to the deceased shareholder’s executor along with any short-term interest due to eliminate the debt.

Buy‑Sell Considerations

The following is a checklist of considerations that should be addressed, agreed upon by the owners of a business, and then implemented into a formal buy-sell agreement:

1. What are your objectives for the ownership of the business upon the following? Which triggering events do you want to create a contingency plan for?

1. Death of an owner
2. Disability of an owner
3. Retirement of an owner
4. Termination of employment, with or without cause; will all of the owners be required to work full-time for the company/ partnership?
5. Divorce of an owner
6. Bankruptcy of an owner
7. Loss of professional license

2. Consider whether to create obligations or options. For example, upon the death of a shareholder, do you want the deceased shareholder’s estate to have the obligation to sell the shares to the surviving shareholders? Do you want the surviving shareholders to have the right or the obligation to purchase the shares from the deceased shareholder’s estate? What if the triggering event is the bankruptcy of a shareholder? Should the other shareholders have the right or obligation to purchase those shares?

3.Valuation method. What should the agreement say about the sale price when a triggering event occurs? Common methods include using a fixed value, a fixed formula, an annual valuation by an appraiser, or an appraisal upon a certain trigger, such as death.

4.Alternate valuations. Should the value of an ownership right be valued at a lower price for different triggering events? For example, if an owner is terminated for cause or terminates their employment prior to a stated retirement age, should the price the remaining shareholders have to pay be reduced?

4.Terms of any sale. Should the agreement call for a lump sum payment upon the occurrence of certain triggering events, or should it allow for an installment sale over a period of years?

5.If an installment sale, what interest rate should be applied? Payment Caps—Consider a payout limitation (amount to be determined) for each calendar year in which a buyout purchase price is payable by the company (to protect the company from having to make prohibitive payments in any calendar year).

6. What property should the agreement cover? Does the business entity own everything, or are there related properties (i.e., real estate that is individually owned)?

7. Are there exceptions that you want? For example, do you want to reserve the right to gift or bequeath shares to a child without the approval of the other shareholders?

8.Tax issues. There are numerous income, capital gains, and estate tax issues that need to be considered when deciding on the structure of any transfer of ownership called for in the agreement.

9. Agreement must be coordinated with other documents and agreements, such as shareholder agreements and articles of incorporation.

10.Buyout in the event of a deadlock. If the owners were to have irreconcilable differences with respect to the direction of the business or any other related matters, how should such deadlock be resolved so as not to paralyze the business? In other words, should the agreement provide for a shotgun buy-sell mechanism whereby owner X would be required to propose a price for his or her ownership interest to owner Y, who would then be required to either buy the ownership interest of owner X or sell his or her own ownership interest to owner X at that price?

11.Performance buyout. If a party fails to meet performance requirements, will the other owner have the option to buy out his or her ownership interest? What should be used as the performance criteria?

12. Are the owners permitted to engage in or possess interests in other business ventures? If so, should such owner be required to offer the company or any other owner the right to participate in these business ventures? What about business ventures that are in competition with the company?

13.Restrictive covenants for owners/employees. What are the geographic and time restrictions for the non compete? Will each owner, after leaving the company, be prohibited from soliciting the company’s employees or clients? If so, for how long? Will each owner be required to enter a confidentiality agreement with the company, prohibiting the owner from disclosing the company’s confidential information?

Basic issues relating to funding the agreement:

1. 1. Funding. Should the agreement create obligations that should be funded and/or risks that should be insured? An unfunded buy-sell agreement can cause more problems than having no agreement at all.
   2. What is the best way to fund the obligations and the most cost-efficient means of insuring the risks?
   3. Make sure funding matches with the agreement. (Stock redemption agreement should not be funded with personally owned policies.)
   4. If the company/partnership is the owner of such a policy, will the insured be entitled to purchase the policy if he or she left the company/partnership?
   5. If the life insurance is purchased and proves insufficient to pay for the ownership interest transferred, how will the balance of the purchase price be paid (over time, on what terms, interest rate, years to pay, monthly/quarterly/annual payments)?
   6. Specific to disability insurance. The buy-sell agreement should define “disability” in a manner that is the same as the disability buyout policy defines “disability.” Otherwise, the agreement may trigger a forced buyout many months before the policy pays out a benefit. Or worse, the agreement could trigger a buyout based on how “disability” is defined in the agreement, yet the owner may not meet the definition of “disability” in the insurance policy and no payment will be made, leaving the company with a useless policy and an obligation that they are short on cash to meet.
   7. The probability that a business owner will become permanently disabled while they own the business is many times higher than the probability of them passing away while they own the business. However, owners tend to purchase life insurance to fund their buy-sell obligations and not realize that insurance carriers offer disability buyout insurance that will provide funding to help them meet their buy-sell obligations in case of the disability of an owner. These policies provide tax-free cash payments to the company should a business owner becomes disabled. These funds may then be utilized to meet their obligations under a stock redemption agreement.

Buy‑Sell Structures—Summary

Conclusion

There are buy-sell agreements designed to fit a variety of types of organizations and managerial situations. The agreements require coordination of company documents, and funding. As company ownership changes, new policies are required. Agreements may require periodic review and adjustment.

Buy-sell agreements assure owners that they will be able to cash out when they want to retire. The agreement will define how their shares will be valued and the source of the cash to pay for the shares. Buy-sell agreements serve as guidelines for friendly and less than friendly business separations. They can save many times their cost in legal fees, management time, and lost focus in the event of a disputed business separation. If a business is worth saving, it requires a buy-sell agreement.