By Robert J. Lord
What happens if a business owner dies, withdraws from the business, or wants to sell his or her shares? Without a buy-sell agreement, the remaining owners can lose control of the business. The implementation of a buy-sell agreement, however, should be handled carefully. Having an improperly structured buy-sell agreement could be worse than having no buy-sell agreement at all.
A buy-sell agreement permits (or requires) the company or the remaining shareholders to buy back a departing shareholder’s stock. In addition to controlling ownership, a buy-sell agreement:
o Creates liquidity for a deceased shareholder’s heirs.
o Provides an “exit strategy” under which owners can withdraw from the business and dispose of their interests.
o Helps avoid disputes over the value of stock by setting the price or a formula for determining the price.
o Provides for an orderly succession of the business to family members or others.
o Helps establish the value of the business for estate and gift tax purposes.
The obligation to buy or sell shares of a company typically is triggered by any one of the following events:
+ Termination of Employment
In structuring a buy-sell agreement, careful consideration should be given to the circumstances under which a shareholder’s employment is terminated. A shareholder’s employment may be terminated by the company or by the shareholder. If the company terminates the employment, the termination shall may be “for cause” or “not for cause.” If the shareholder terminates his own employment voluntarily, the termination may be in the prime of his career or may be a termination in the nature of retirement. In most cases, each of the foregoing situations will call for a different set of buy-sell requirements.
In addition to the ordinary triggering events, a well-drafted buy-sell agreement also should address the bankruptcy or divorce of a shareholder.
Optional or Mandatory Purchase Requirement
For each triggering event under a buy-sell agreement, the agreement should specify whether the purchase of the departing shareholders shares is mandatory or optional. Many buy-sell agreements provide for a mandatory purchase in every situation. Quite often, however, that is not appropriate. For example, if a shareholder’s employment is terminated for cause, should the company or the remaining shareholders be forced to fund a large stock purchase? If the bankruptcy of a shareholder is addressed in a buy-sell agreement, the purchase of the bankrupt shareholder’s shares ordinarily should be optional.
Valuation of a Departing Shareholder’s Shares
Valuation of a departing shareholder’s shares is perhaps the most difficult part of structuring a buy-sell agreement. There are several options to consider. The buy-sell agreement can provide for an appraisal of the departing shareholder’s shares at the time of his or her departure. Alternatively, the buy-sell agreement can specify a formula for valuing a departing shareholder’s shares. A third option is to require the company and shareholders to agree on an annual basis what the value of a departing shareholder’s shares will be for the following year. Each valuation method has its advantages and disadvantages. For example, an appraisal requirement probably best ensures that both the remaining shareholders and the departing shareholder will be treated fairly. Appraisals, however, are expensive and the appraisal process is time consuming.
Buy-Sell agreements can be used to implement an effective dispute resolution mechanism commonly known as a “forced buy-sell” or “shotgun buy-sell” arrangement. Under this arrangement, a shareholder may provide notice to another shareholder and state the price per share at which one will be required to buy the other’s stock. The other shareholder then is required to choose whether to be the buyer or seller at the stated price. This mechanism often allows co-shareholders who no longer get along with one another to sever their relationship in an efficient and fair manner, without the need for expensive appraisal or litigation.
Types of Buy-Sell Agreements
There are generally two types of buy-sell agreements: the cross-purchase agreement and the redemption agreement. Under a cross-purchase agreement, a departing shareholder’s stock is purchased by one or more of the other shareholders. Under a redemption agreement, the corporation purchases the stock. Often, buy-sell agreements are funded with insurance on the shareholders’ lives. If a redemption agreement is used, the corporation is the owner and beneficiary of the policy. Under a cross-purchase agreement, each shareholder purchases insurance on the lives of the other shareholders.
Although cross-purchase agreements are more difficult to administer, they may be advantageous tax wise, in two respects. First, if insurance is used to fund the purchase obligation, the purchasing shareholders essentially receive a stepped-up basis in the stock, which reduces the amount of capital gains tax they must pay if they sell the stock.
Suppose, for example, that Smith and Jones are the cofounders of ABC, Inc. Each contributes $10,000 to ABC in exchange for 50% of ABC’s stock. If ABC, Smith and Jones enter into a stock redemption agreement funded by $1,000,000 insurance policies on the lives of Smith and Jones and Smith dies when the value of the business is $2,000,000, ABC will collect the insurance proceeds and buy back Smith’s stock for $1,000,000. Jones then will own 100% of ABC’s outstanding stock, but his basis only will be $10,000. If Jones then sells his stock for $2,000,000, he will realize $1,990,000 in taxable gain.
If, instead, Smith and Jones enter into a cross purchase agreement, Jones will collect the insurance proceeds and purchase Smith’s shares, thereby increasing his tax basis to $1,010,000 (the purchase price plus his original capital contribution). If Jones sells his stock, his taxable gain will be only $990,000 rather than $1,990,000.
Second, cross-purchase agreements avoid alternative minimum tax (AMT) problems that sometime arise under redemption agreements. Life insurance proceeds generally are tax-free to the recipient, but a corporation may incur AMT liability as a result of receiving life insurance proceeds.
This article contains only general information and is not to be relied on as legal advice. For advice on your individual situation, consult a lawyer in your jurisdiction. No attorney/client relationship arises from use of this article.
By Robert J. Lord