Buy-Sell Agreements

By Parag Patel, Esq.

What if your business partner retires, sells her portion of the business, or gets a divorce? To make sure there is a smooth transition following the departure of a business partner, it is important that business owners in limited liability companies, corporations and partnerships write a buy-sell agreement at the start of their relationship. A buy sell agreement provides for an orderly disposition of business interests and is beneficial in setting the value for estate tax purposes.

In General

An Estate plan which is appropriate for the owner of a small business can involve complex tax and non-tax issues when developing a buy-sell agreement among shareholders.

From the standpoint of the corporation and the remaining shareholders, a properly planned buy-sell agreement normally will restrict the transfer of stock and provide for the orderly continuation of the ownership and control of the corporation upon the happening of certain events, such as the death, disability or retirement of a shareholder. The buy-sell agreement can prevent unwanted outsiders from becoming shareholders and eliminate the need for negotiations with surviving spouses and/or children. A buy-sell agreement may perform the role of a succession plan, providing for continuity or orderly succession of corporate management. Provisions may be made to anticipate the cash liquidity needs of the purchasing shareholders by putting in place life insurance to partly or wholly fund the future purchase.

From the standpoint of the estate of a deceased shareholder, the existence of a buy-sell agreement can assure the estate a liquid asset rather than an unmarketable interest in a small business. The planning process can provide the decedent, while alive, with the opportunity to negotiate and obtain the fairest or best price for his or her stock. In a retirement or disability situation, the buy-sell agreement provides a market for the stock and provides an additional source of retirement or disability funds.

Finally, if properly drawn, the buy-sell agreement may establish a valuation of the stock for estate tax purposes.

Types of Restrictions in Buy-sell Agreements

The buy-sell agreement may contain a variety of restrictions on the transferability of stock.

The most usual restriction is a limitation on transfers to certain classes of persons, such as members of a family who are working in the business. This is usually combined in the case of a lifetime buy-out with a first option or right of first refusal to the corporation, the other shareholders or some combination of both. In the case of the death of a shareholder, usually there is a mandatory purchase requirement by the corporation or the other shareholders.

Frequently, the same agreement will provide for an option or right of first refusal in a lifetime situation and a mandatory buy and sell on death.

The same agreement may also differentiate among various lifetime situations. For example, disability or retirement may require a mandatory buy and sell. Any other lifetime situation may create an option or right of first refusal. This differentiation usually is a function of the ability to pay. Disability and death buyouts may be funded by insurance, and retirement can be anticipated. Other situations may depend on the corporation's or shareholders' ability to pay, and must be left to discretion based on the facts at the time.

Events That Activate Buy-sell Provisions

The agreement may provide that any one of the following events will give rise to the option, right of first refusal or obligation to buy and sell:
1. Death.
2. Disability.
3. Termination of employment.
4. A shareholder's desire to sell his or her stock to a non-shareholder.
5. Divorce (to keep the ex-spouse from owning stock).
6. Bankruptcy.

Establishing the Purchase Price

Establishing the purchase price is one of the most critical provisions of the agreement. Too often, a valuation is selected that yields an inappropriate price when finally used. If the agreement provides for a purchase price that is revalued by the Internal Revenue Service for estate tax purposes, the estate could be liable for taxes based on the IRS revaluation, where it has only received the value based on the formula in the agreement. This could result in an unanticipated shift in the beneficial enjoyment of the estate.

Some of the more traditional methods of valuation are book value, appraised value, capitalization of earnings, an agreed fixed dollar amount and various formula provisions thought to reflect the idiosyncrasies of a particular corporation.

Methods of Funding and Payment

Methods of funding the buy-sell agreement should be selected so there will be some certainty about the source and extent of liquid funding. When there is a reliable source of funding, payment in full at the closing may be possible.

If funding is not available, the entire payment, or any part, may be paid in installments, with interest, and usually evidenced by a promissory note.

Life insurance funding is usually recommended unless age or health concerns do not allow it. If the parties want to fund the buy-sell agreement for retirement, it may be advisable to acquire a form of whole life or universal life expected to build large accumulations of cash value that could be withdrawn at the appropriate time.

Disability buy-out insurance also should be considered as a funding source for any agreement upon the disability of a shareholder. Care should be taken to have the agreement require payment only at the time funds are available under the insurance policy.

If the payment is not a lump sum cash payment at closing, the parties should consider some type of security arrangement to help insure deferred payments. Types of security arrangements might include personal guarantees from other shareholders or the corporation; mortgages or security interests in certain real estate or other corporate assets; pledge of the purchased stock; a bank standby letter of credit; life insurance on obligor individuals or key persons, collaterally assigned to the holder of the note; or a related corporation guarantee.

Corporate Redemptions

In an Entity Purchase Agreement, the corporation is a party to the agreement and is also the purchaser. The corporation pays the purchase price with after-tax dollars but can deduct interest payments as an ordinary business expense.

An Entity Purchase Agreement often can be conveniently funded with life insurance owned and paid for by the corporation insuring the lives of each of the shareholders subject to the agreement. The premiums are not deductible.

Alternatively, in the Cross Purchase Agreement, the other shareholder or shareholders are the purchasers of the stock of a selling shareholder. If there is more than one potential purchaser, the proportions each has the option to purchase, or is required to purchase, should be set out.

Purchasing shareholders acquire an income tax basis in the stock they purchase equal to the amount paid. If insurance is used, the purchasing shareholders should own the policies and should be the beneficiaries, so it is their money used to acquire the stock.

A Cross Purchase Agreement avoids concern over whether the corporation will have sufficient surplus to redeem stock. If there are more than two or three shareholders, however, the Cross Purchase Agreement can become unwieldy and may require a large number of life insurance policies. Each shareholder must own a life insurance policy on each other shareholder, and the shareholders pay the premiums individually. Premium payments may be inequitable if there is a large disparity in the percentage ownership of the stock, or in the ages of the parties. Awkwardness also arises from the fact that the estate of a deceased shareholder (or a departed shareholder in the case of a lifetime sale) will own life insurance policies on all of the surviving or remaining shareholders. A method should be included to require (or permit) the surviving or remaining shareholders to purchase the insurance then held by the estate or ex-shareholder.

Conclusion

A successful buy-sell agreement must resolve many difficult tax and planning issues, while simultaneously addressing business management and succession concerns.

Stretch IRA - How Your IRA Can Survive Several Generations

The stretch IRA concept is a wealth-transfer strategy that can help you extend the period of tax-deferred earnings on your retirement assets. After the owner of the IRA dies, the beneficiaries will also have the longest allowable period of tax-deferral on the required distributions of the IRA assets. This strategy can allow distributions from your retirement assets to be extended over several generations. Because of this, your family could save significant dollars in income taxes over their lifetimes.

A stretch IRA strategy can be established at any time, as long as you have named an individual person as the beneficiary. It's also important to name an individual person as a contingent beneficiary in case your primary beneficiary predeceases you. If set up correctly, your beneficiaries should be able to take their required IRA distributions over their individual life expectancies.

However, there are a number of steps that need to be followed to put this strategy in place. These steps include the following:

1. Selection of individual beneficiaries.
As previously mentioned, you will need to designate an individual beneficiary. Although there might be certain reasons for naming a trust as a beneficiary (e.g., asset protection for the beneficiaries), you should keep in mind that you will jeopardize the ability to use this strategy if you do it. Even with a qualified trust, distributions must be paid out over the life expectancy of the oldest beneficiary. With this in mind, you could jeopardize you ability to stretch out distributions to your grandchildren if you name a trust as the beneficiary.

2. Discuss your plans with an experienced advisor.
The benefits of this strategy could also be jeopardized if the IRA is not set up properly. Therefore, you need to speak with an experienced tax advisor who has worked with this strategy before.

3. Establish and maintain separate accounts for your beneficiaries.
If you have two or more beneficiaries, you need to set up a separate account for each one of them. You should also designate a certain percentage of you IRA assets to each of your beneficiaries. By doing this, each beneficiary can then choose to have their share distributed over their individual life expectancy.

4. Inform your beneficiaries of your plans.
You should also let your beneficiaries know about their future interest in your account when you pass away.

There are a couple of other things to keep in mind. The names of the account holder and the individual beneficiary must appear on the IRA account, and the beneficiary distributions must begin no later than Dec. 31 of the year after the death of the account holder. If these rules are not followed, the funds from the IRA could be exposed to a significant income tax penalty for missing the required mandatory distribution (50% of the distribution that should have been taken).

On a final note, it should be remembered that this strategy may not be suitable for everyone. For example, if you think that you will need access to your IRA money to meet your daily living needs during retirement, then this strategy might not help you. Please note I always advise people to consult with their own qualified legal advisor prior to making any decisions.

Do you want to know more about the benefits and restrictions of the stretch IRA strategy? Email or Call me.