TABLE OF CONTENTS
Purposes of the Buy-Sell Agreement
For the entity
For the patriarch of the family
For the children of the patriarch
For the grandchildren of the patriarch
For unrelated owners of the business
For the patriarch in anticipation of his retirement or potential incapacitation
For the surviving owners of the business
Types of Buy-Sell Agreements
The number of owners of the business
The age of the owners
Credit considerations
The relative income tax brackets of a C corporation and its shareholders
Transfer for value considerations
Alternative minimum tax
Accumulated earnings tax
Capital gains tax treatment of the sale proceeds
Section 318 attribution rules
Family attribution rules
Estate and trust attribution rules
Is this redemption a sale or a dividend
Exceptions under Code Section 302
The redemption is substantially disproportionate
Waiver of attribution rules when a shareholder retires
Waiver of attribution rules when a shareholder dies
Exception for redemptions by a C corporation to pay an estate’s taxes and expenses of administration
Basis considerations
The deductibility of interest paid on deferred sale proceeds
Excessive life insurance
If the entity is owned by several families or by several family groups
The hybrid buy-sell agreement
Transfer Restrictions
Permitted transferees
Triggering Events
Death
Permanent disability
Termination of employment or engaging in competition
Retirement
Bankruptcy
Divorce
Pledges of an ownership interest
Any attempted sale to an “outsider.”
Setting the Purchase Price
What is “fair market value”
Periodic agreement of the owners
The formula approach
The appraisal approach
Setting a special “cut throat” price
Valuation discounts
Fixing the Transfer Tax Value of the Ownership Interest
Grandfathered buy-sell agreements
The present rules
Exceptions to the general rule
The exception for unrelated owners
Meeting the requirements of Code Section 2703 does not guarantee the result
What if the price set in the agreement is not binding on the IRS
Some concluding thoughts on pricing options
Funding the Buy-Sell Agreement
The entity’s ability to pay for the ownership interest
The credit purchase of the ownership interest
Using life insurance to fund the Agreement
Special Buy-Sell Provisions for Partnerships
Special Buy-Sell Provisions for Limited Liability Companies
Special Buy-Sell Provisions for S Corporations
Outline of Key Issues for Agreements Among Equity Owners
Agreement Concerning Stock
Rights of First Refusal and Co-Sale (Tag-Along) Rights
Registration Rights Provisions
Agreement To Be Bound By Buy-Sell Agreement
Cross Purchase vs. Redemption and Type of Entity
LLC Operating Agreement
Some Common Mistakes in Buy-Sell Agreements...... 159
1
Buy-Sell Agreements
By
Eric A. Manterfield
A well drafted buy-sell agreement is a critical tool for planning the successful succession of a family business. It can keep ownership of the business in the family, avoid unintentional termination of an S corporation election and can provide a market for the sale of an ownership interest in the event of certain triggering events.
The provisions of a buy-sell agreement can be contained within a separate document executed by the shareholders and a corporation, within an LLC operating agreement or within the partnership agreement for a family limited partnership. While the planning considerations are typically identical whether the entity is a corporation, LLC or family limited partnership, there can be significant differences.
Except as otherwise specifically noted in this paper, all references to the “agreement” will mean and refer to the transfer restrictions relating to each of those entities.
Purposes of the Buy-Sell Agreement
For the entity
. The Agreement can be used to keep ownership of the entity within a family or a limited group of owners by restricting gifts or sales to outsiders. It can void any transfer which would terminate an S corporation election or would terminate a partnership. If the entity is a professional corporation, the agreement can void the transfer of an ownership interest with would disqualify the entity for that purpose.
For the patriarch of the family
. The Agreement can provide the assurance that ownership interests will not be transferred to non-family members, including in-laws. While many of my clients employ sons-in-law and daughters-in-law in the family business, several are concerned about letting ownership pass outside of the blood family. Once ownership gets into the hands of in-laws, they fear that it will later pass to even more distant, unknown owners.
The Agreement can lead the patriarch to consider the future management of the family business after he is no longer the manager. How will the business continue after the retirement, incapacitation or death of the patriarch? How will the surviving children manage the business in the absence of a strong-willed entrepreneur?
The Agreement can provide a mechanism for the patriarch to sell control to one or more business children, with payment to be made over time, so as to treat fairly other non-business children with the sales proceeds.
The Agreement can provide a forum for the resolution of family business disputes.
The Agreement can require the business children to purchase over time any ownership interest which is given to non-business children, either with or without the consent of the non-business children.
The Agreement can provide a market for the redemption or sale of the patriarch’s unmarketable ownership interest with a predetermined mechanism to determine the price to be paid. The business owner’s personal representative need not negotiate the purchase of the ownership interest from a weak position, which easily could be the case with the owner of a minority interest in the business.
For the children of the patriarch
. The second generation of owners looks to the agreement’s continued restriction on the transfer of ownership outside of the immediate family. While the transfer of outright ownership to the spouses of the second generation is typically prohibited, tax planning strategies can be permitted, including gifts to a QTIP trust.
Because transfer of ownership to members of the third generation (or to trusts for their benefit) is permitted, the opportunity exists to shift future appreciation to subsequent generations.
Some agreements among the children of the patriarch may require that all owners be employees of the business, with the ownership interest of any non-employee child to be purchased by the business or the other owners. Provisions of this type may minimize the conflict which can exist when the employee owners take some portion of the earnings out in the form of compensation (with the remaining earnings to be reinvested in the business), while the non-employee owners want to minimize salaries and maximize dividends and distributions to all the owners.
For the grandchildren of the patriarch
. As cousins become owners, having a mechanism to keep the business in the family, to resolve family disputes and to elect successor managers becomes even more critical. As grandchildren seek to withdraw from the business, the agreement can provide a market for their ownership interests; further, it can give the business itself or the other owners the right to match any offer made by a non-family member.
For unrelated owners of the business
. Unrelated business owners typically do not want to do business with spouses of the current owners and, perhaps, even their children. A mandatory sale upon the death of each owner is not unusual. Nevertheless, consideration should be given to deferring tax to the death of the survivor between the owner and his wife through use of a QTIP trust and to passing appreciation to trusts for the children (whose stock must be sold upon the death of the donor owner in accordance with the agreement).
For the patriarch in anticipation of his retirement or potential incapacitation
. The patriarch who is willing to retire (rather than work until he dies!) can establish an agreement which will provide a source of cash payments for his ownership interest, hopefully with favorable capital gains tax treatment. The patriarch’s recovery of cost basis is tax free, of course.[1] Gain on the amount by which the sale proceeds exceed basis is now taxed at 15%, which is more favorable than the ordinary income tax which must be paid if the payments were styled as compensation for consulting services.
The patriarch who becomes incapacitated can also have an assured flow of cash, in the form of payment for his ownership interest, at a time when his cash needs may increase.
The sale of all the ownership interest of either a retired or a disabled patriarch will also go a long way towards eliminating any continued real or imagined interference with the new owners of the family business.
For the surviving owners of the business
. The agreement can provide for the orderly payment of an ownership interest’s purchase price over time, with interest, hopefully out of the future earnings of the business. The pricing mechanism in the agreement can also minimize any emotional loyalties to the surviving spouse of the deceased owner, who frequently will be an old and valued friend. The surviving owners will have the assurance that they can manage the business without interference from the family of the departed owner, who moves to a creditor status. Finally, the agreement can provide the circumstances under which a departed owner can compete with the business.
Types of Buy-Sell Agreements
There are three types of agreements: (1) the “redemption agreement,” under which the business itself purchases the interest of the departed shareholder; (2) the “cross purchase agreement,” under which the remaining owners of the business purchase the interest of the departed shareholder; and (3) the “hybrid agreement,” under which either the business or the remaining owners may purchase the interest of the departed shareholder.
Here are some considerations when deciding among these alternatives.
The number of owners of the business
. In the case of a redemption agreement, the business typically purchases a policy insuring the life of each owner, with the death benefit equal to the anticipated purchase price in the event of an owner’s death, payable to the business which then uses the proceeds to redeem the ownership interest of a deceased shareholder. This death benefit must be increased over time as the value of the business appreciates.
In the case of a cross purchase agreement, on the other hand, each owner must purchase a policy on the life of every other owner, with a death benefit equal to the surviving owner’s anticipated pro rata purchase price in the event of an owner’s death.
In the case of a business with only two owners, each owner will acquire a policy on the life of the other owner (no worse than the two policies needed to fund a redemption agreement); however, as the number of owners increases beyond two, the number of insurance policies increases geometrically:
Number of owners Number of policies required to fund a cross-purchase agreement
2 2
36
412
520
630
Funding a cross-purchase agreement can be a life insurance salesman’s dream come true! This potential disadvantage of a cross-purchase agreement among many owners of a family business might be minimized if the owners separately created a partnership or trust to purchase the policies, with the proceeds to be collected by that other entity and used to comply with the terms of the cross-purchase agreement.
The age of the owners
. A cross-purchase agreement can place a heavy burden on the younger owner who seeks to use life insurance proceeds to buy the ownership interest of an older owner. The older owner may not even be insurable. If insurance is available on the life of the older owner, the premium cost may be significant for a younger owner with limited resources. If the business pays the premiums in the case of a redemption agreement, on the other hand, the older shareholder is effectively financing a portion of the cost of his own redemption.
Credit considerations
. Restrictive covenants in lending agreements with the business bank may prevent the redemption of an ownership interest. In addition, the business’ obligation to redeem ownership interests in the future may have a negative impact on the ability of the business to borrow in the future.
The relative income tax brackets of a C corporation and its shareholders
. Premiums paid by the business or its owners are not deductible for income tax purposes; therefore, if a C corporation is in a lower income tax bracket than its shareholders, it may be less expensive for corporation to pay the premiums to fund a redemption agreement.[2]
If a C corporation is in a 15% income tax bracket, it would have to earn $117.65 to fund a $100.00 premium payment to fund a redemption agreement, while a shareholder in the 35% income tax bracket would have to earn $153.85 to fund a $100.00 premium payment to fund a cross purchase agreement. On the other hand, if the C corporation is in a 34% bracket and the shareholders are all in the 28% bracket, the after income tax cost to the shareholders (to fund a cross-purchase agreement) will be less than the after income tax cost to the C corporation (to fund a redemption agreement).
Because the owners of an S corporation, an LLC or an FLP will report as taxable income the dollars used to pay the premiums, the after income tax cost to the owners will be identical whether a cross-purchase or a redemption agreement were utilized.
Transfer for value considerations
. The owners of a business which adopts a cross-purchase agreement typically fund the anticipated purchase price to be paid upon the death of an owner with life insurance. Each owner purchases a policy of insurance on the lives of every other owner. When an owner dies, the surviving owners collect the insurance on his life and apply the proceeds to the purchase of the deceased owner’s interest.
But what does the deceased owner’s estate do with the policies which he owned on the lives of the other owners? If those policies are sold to the insured, there is no transfer for value problem.[3] The surviving owners can each decide whether to continue ownership of this policy on their own lives or cash them in; nevertheless, each surviving owner now needs to increase the coverage on the other surviving owners to replace the insurance which had been owned by the deceased owner.
If the deceased owner’s estate sells the policies on the lives of the surviving owners to each of the surviving owners except the insured (so as to avoid requiring the survivors to purchase more insurance), the purchasers of these policies will have to report the insurance proceeds, when received, as taxable income to the extent the proceeds exceed the purchase price and any post purchase premium payments.[4]
Alternative minimum tax
. The alternative minimum tax may apply to 75% of the life insurance proceeds payable to a C corporation pursuant to a redemption agreement unless the corporation’s average gross receipts for the prior three years do not exceed $7.5 million.[5] Adjusted current earnings of the C corporation, for purposes of the alternative minimum tax, include life insurance proceeds in excess of the corporation’s basis in the policy.[6] Therefore, a redemption agreement funded with life insurance on the lives of each shareholder of a C corporation may be taxed at 15% (75% of proceeds taxed at C corporation’s 20% alternative minimum tax rate = 15%).
A C corporation which adopts a redemption agreement funded with corporate owned life insurance policies must also include in its adjusted current earnings each year the annual increase in the cash value of the policy over the premiums paid that year.[7]
A redemption agreement adopted by an S corporation, an LLC or an FLP does not cause the same alternative minimum tax problem because it is the business owners (rather than the business) who are subject to the individual alternative minimum tax, which does not include the adjustment for life insurance proceeds.
Accumulated earnings tax
. If a C corporation sets aside liquid assets to fund the purchase of shares of its owners, it may be subject to the accumulated earnings tax.[8] Accumulated earnings are those which are in excess of the normal operating needs of the C corporation. Most C corporations are entitled to accumulate up to $250,000 without having to show that the accumulation is necessary for the operation of the business.[9]
Presumably, the accumulated earnings tax will not be a problem for a C corporation which purchases insurance on the lives of its owners, rather than accumulates earnings to pay the purchase price.
Accumulating earnings to fund the purchase of a shareholder’s stock may be a legitimate need of the corporation, particularly in the case of a minority shareholder.[10] Earnings accumulated during the taxable year of a shareholder’s death, to be used to fund a Section 303 redemption from the deceased shareholder’s estate, will be accumulated for the reasonable needs of the corporation and will not be subject to the accumulated earnings tax.[11]