by Ronald P. Weiss, Esq., Bulkley. Richardson, and Gelinas, LLP
A buy-sell agreement, as I will use the phrase in this article, is an agreement to purchase or sell a business interest at a determinable price and time, and on predetermined terms. The purchase or sale may be mandatory or optional, and the agreement may give sale or purchase rights to one party or to all of the parties. This should not be confused with transfer restrictions, which may or may not be combined with a buy-sell arrangement.
Lawyers, accountants and insurance agents are constantly urging owners of closely-held businesses to enter into buy-sell agreements for their ownership interests. I have done so countless times, for reasons I will get into later. Before I do, and at the risk of offending my fellow professional advisors and being branded a fool, permit me to tell you why you may not want one.
Real life has a way of trumping the best plans. A family member with equity in your business may become ill or disabled. For family or other reasons, you may not want, or be able, to buy his interest when he becomes disabled, and you may decide to continue his compensation and benefits long after you would do the same for a non-owner, unrelated employee. Or, the value of your business may grow faster than any funding mechanism you can afford to enable you to purchase a substantial interest from another owner. Your business may not have the cash flow to prefund a buy-out or to honor its commitment to buy out a fellow owner when the time comes. Or, you may have children to whom you might like to pass your interest in the business, but it is too soon to be sure whether they are interested or capable.
In any of these and many other situations, you might like some flexibility to consider what kind of buy-out, if any, would be appropriate, and at what price. You may believe that you paid a portion of what you owe your disabled fellow owner when you carried him for a while. You may not be able to afford sufficient insurance or other savings to pre-fund a buy-out, and you may not be sure of your ability to pay for a buy-out when the time comes. You may not want to cut off your children from the possibility of succeeding to your ownership.
If you are bound by a buy-sell agreement, you may have less room than you might like to consider what is to be done. An owner may be wise to deal with a buy-out when the time comes rather than by prior agreement. After all, if pre-funding is an issue, nothing bars owners from establishing a sinking fund for possible buy-outs or from buying insurance on each other or having their business buy it on the owners. The insurance proceeds or sinking fund could be used to fund a buy-out, or just to provide capital to continue the business after the loss of a key employee/owner.
Why read on, you may be thinking to yourself? Well, lest you believe that, in a totally uncharacteristic fit of altruism, I have saved you legal fees, and granted you a license to further procrastinate on a matter of importance, I feel compelled to tell you (albeit in a very abbreviated and incomplete fashion) what else I tell my clients about buy-sell agreements, and some of the issues that they should think about if they are considering such an arrangement.
So, what good is a buy-sell agreement? It can:
- Help you plan what will happen to your controlling interest
- Provide a market for minority interests
- Be helpful for estate and gift tax planning
- Over time, provide a history of equity valuations that can be useful for a variety of tax purposes
- Create valuation methods for cross-purchases, redemptions, and buy-ins
- Create some basis for valuation of interests to help in resolving disputes among owners;for instance, those arising in the case of mergers or squeeze-outs
- Be helpful as a basis for valuing interests in case of divorce
A buy-sell agreement used to be able to do more: it used to let owners establish a relatively low value for their ownership interests for estate tax purposes. However, in 1990 the Internal Revenue Code caught up with that tax dodge, and now requires that intrafamily transfers be bona fide business arrangements at an arm’s length price, and not devices to transfer property to family members for less than full and adequate consideration. Some old agreements still can be useful, so don’t amend or rip up your old agreements before you seek competent advice. Of course, you can still fix a low price by agreement with non-family members.
There are several types of buy-sell agreement: redemption, cross-purchase, and hybrid. Each can make purchase mandatory or optional under various circumstances. Each is more or less appropriate depending on the tax status of the entity whose interests are involved. None of them must necessarily require the purchase of all of the seller’s ownership interest. Moreover, any agreement may require a purchase or may merely grant an option or a right of first refusal.
A redemption agreement casts the entity whose ownership interests are the subject of the agreement in the role of buyer, option holder or possessor of a right of first refusal.
A cross-purchase agreement casts other owners in one or more of those roles.
A hybrid either mixes and matches or makes redemption or cross-purchase the secondary method if the interests are not all purchased under the first method. Events that might give rise to purchase and sale include death, disability, termination of employment, a desire to sell to a third party, and involuntary transfer (e.g. by bankruptcy or as a result of a creditor obtaining the ownership interest to satisfy an obligation). If you own stock in a corporation but don’t want your estate to sell all of your stock at your death, you should check with your tax advisor to see when partial redemptions may be appropriate to help pay estate taxes and funeral and administrative expenses.
In the case of corporations, the major tax differences between a redemption and cross-purchase are:
- Basis: In a cross-purchase, the other purchasing stockholders get an increase in the tax basis of their ownership interests equal to the amount paid. In a redemption by a C corporation, the other stockholders get no basis step-up In a redemption by an S corporation, the surviving stockholders can get a step-up in basis equal to the tax free insurance proceeds received by the corporation; however, you should get advice on how to accomplish this from your tax advisor.
- Gain or loss on sale: In a cross-purchase, living sellers have capital gain or loss. The estate of a deceased stockholder should recognize no gain or loss except to the extent the shares are worth more or less on the date of sale than they were valued at for federal estate tax purposes. In a redemption, capital gain treatment as in a cross-purchase would apply, unless the redemption is treated as a dividend, which may happen if you are not careful.
- Insurance proceeds: In a cross-purchase, insurance proceeds would be taxable only if the transfer for value rules apply because the policy was purchased from its original owner by an ineligible person. In a redemption, insurance proceeds received by a C corporation could trigger the corporate alternative minimum tax. The corporate alternative minimum tax does not apply to S corporations.
- Accumulated earnings tax This does not apply to individual purchasing stockholders in a cross-purchase. In a redemption, if a sinking fund is employed for funding, the accumulated earnings tax may apply to a C corporation, but not to an S corporation.
- Deductibility of installment interest In a cross-purchase, the investment interest limitation rules may apply. In a redemption, the interest should be fully deductible.
There are really only three ways to fund the purchase of an ownership interest: insurance, savings, and installment purchases dependent on cash flow. Most of the time, a combination of these funding techniques is employed. Insurance premiums on policies purchased for these purposes are not deductible. The use of insurance in a cross-purchase situation with more than a few owners can get complicated. If you have five owners, you need 20 policies! Or else you might get an escrow agent to hold one policy on each of the five, and each owner could contribute to the payment of premiums on policies on the four other owners.
Each form of agreement sets a price for the purchase and sale of the ownership interests. Valuation formulas are a subject for another article. However, experience has taught me that any purchase price formula that is dependent on periodic review by the owners does not work. Owners almost never get around to the review, and the agreement price gets stale.
In addition to the foregoing considerations, there are state law solvency issues raised by a corporate redemption agreement. Moreover, in a cross-purchase situation, insurance proceeds and cash value, and other assets of a purchasing owner that were supposed to be used for purchase of an ownership interest, can be reached by creditors of the purchasing owner. The same is true of corporate assets to be used for a redemption, but that situation is more easily monitored. Finally, there is the related issue of restrictions on transfer of ownership interests, which must in every case be carefully considered, and may involve many of the same issues raised above.
You should think through all of the issues involved with a buy-sell agreement, whether you end up executing one or not. In my experience, most business owners finally conclude that the advantages outweigh the significant disadvantages, and even if you decide not to enter into a buy-sell agreement, careful consideration of all of the issues will permit you to begin to address the very real problems these agreements are designed to resolve.
Permit me to end by describing one of my favorite paradoxes in business planning. Joe and Pete are equal partners of approximately the same age. They enter into a cross-purchase agreement, and each purchases term insurance on the life of the other to fund his buy-out obligation on the death of the other. When Joe dies first, Pete pays Joe’s estate with the insurance proceeds in return for 100% of Joe’s ownership interest. Presumably, Joe’s insurance on Pete then lapses or Pete purchases the policy, but that does not matter.
Now consider what would have happened if Joe and Pete had each bought the same amount of life insurance on himself, not on the other, and had each agreed to sell his ownership interest in their business to the other for a dollar. Their premiums would have been roughly the same. When Joe dies under the second arrangement, his estate gets the same life insurance proceeds it would have gotten from Pete, and it gets a dollar.
Could it be that under the first arrangement, Joe’s estate actually gave away Joe’s ownership interest for nothing, merely collecting on an insurance policy, and under the second it at least got a dollar? It would seem so. Moreover, if Joe had used an irrevocable life insurance trust to buy the insurance on his own life, the value of the policy would not have been included in his estate, unlike the proceeds from the sale of the ownership interest. Of course, Pete would not have gotten a step-up in the tax basis of his ownership interest that way, but that is only relevant
if Pete disposes of his interest before he dies, and is probably of little consolation to Joe’s family when it eventually pays roughly half of the proceeds from the sale of Joe’s stock to the government in estate taxes. There is a moral here somewhere.