AN OVERVIEW
OF
BUSINESS AND TAX PLANNING ISSUES
THAT ARISE IN STRUCTURING
BUY-SELL AGREEMENTS
AND
PLANNING FOR BUSINESS BUY-OUTS
Fall 2012
Keith A. Wood, Attorney, CPA
CARRUTHERS & ROTH, P.A.
235 North Edgeworth Street
Post Office Box 540
Greensboro, North Carolina 27402
Telephone: (336)478-1185
Facsimile: (336)478-1184
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Keith Wood, CPA, JD, an attorney with Carruthers & Roth, PA, in Greensboro, NC, is certified
by the North Carolina State Bar as a board certified specialist in estate planning and probate law.
Keith's practice areas include tax planning and representation of clients before the Internal
Revenue Service, corporate law and business transactions, and personal estate planning. Keith is
a frequent speaker to civic and professional groups on business planning, taxation, and estate
planning, and has authored published articles on these topics.
Keith received his undergraduate degree in Business Administration and his Law Degree, with
Honors, from the University of North Carolina. While in law school, Keith served as the
business manager of the North Carolina Journal of International Law and Commercial
Regulation.
Keith also is an active member of NCACPA and a former member of its Board of Directors.
Keith and his wife, Jody, live in Greensboro with their two children, Edie and Xander.
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Introduction
Any business venture among two or more owners is much like a marriage; it is easy and
painless to get into, but when the honeymoon is over, it can be very disruptive (and expensive) to
untangle the interests of the business partners unless there is a prior agreement or plan in place
which contemplates this very possibility.
A Buy-Sell Agreement is a specific type of business agreement which sets forth the terms
by which business interests will be bought and sold upon the happening or occurrence of certain
future events. Buy-Sell Agreement provisions are commonly found within the terms of:
1. Partnership Agreements;
2. Limited Liability Company Operating Agreements; and
3. Corporate Shareholder Agreements (sometimes called Stock Purchase
Agreements).
In simple terms, the Buy-Sell Agreement is a sort of pre-marital agreement for business
owners. By executing a Buy-Sell Agreement today, the business owners can control, to some
degree, the future disposition of the business. Therefore, like a pre-marital agreement, the Buy-
Sell Agreement provides closely-held business owners with a certain level of security and
predictability to an otherwise unstable and unpredictable relationship.
Careful planning, however, is required in negotiating and structuring the terms of a Buy-
Sell Agreement. Because the Buy-Sell Agreement is structured with a view toward the future,
many unintended income and estate tax results may occur without proper consideration.
For example, the structure of a Buy-Sell Agreement may have drastic income tax
consequences to the outgoing and continuing partners upon the happening of a specified buy-out
event under the Buy-Sell Agreement.
Moreover, in the case of closely held family businesses, the existence of a Buy-Sell
Agreement may provide other very valuable estate and gift tax benefits in addition to assuring
family ownership continuation. Specifically, as we will discuss later, the existence of a Buy-Sell
Agreement may serve to establish or "fix" the transfer value of business ownership interests for
estate planning purposes. Moreover, as we’ll also discuss later, the existence of the Buy-Sell
Agreement may also affect whether gifts and bequests of business interests will qualify for the
marital deduction or the $13,000 annual gift tax exclusion for federal estate and gift tax
purposes.
This outline will focus on the structuring of Buy-Sell Agreements among business
owners. The discussion will be divided into two (2) parts.
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Business Planning Issues.
In Part One of our discussion, we will review the role of Buy-Sell Agreements in
business planning for closely-held business clients and the important role the client's tax advisors
will play in this Business Planning process.
Tax Planning Issues.
In Parts Two through Four of this presentation, we will review selected income and
estate tax issues that often arise in structuring buy-outs in closely-held businesses.
Many of the concepts discussed in this outline will apply equally regardless of whether
the business enterprise takes the form of a partnership, corporation or limited liability company.
Furthermore, many of the considerations in drafting Buy-Sell Agreements for unrelated business
owners will likewise apply in the context of the family business. To the extent practical, we will
try to highlight the differences which arise in Buy-Sell Agreements for family businesses versus
businesses owned by unrelated parties.
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PART ONE:
BUSINESS ISSUES IN STRUCTURING BUY-SELL AGREEMENTS
I. Why Are Buy-Sell Agreements So Important In Business Planning?
To understand the importance of Buy-Sell Agreements for business and tax planning,
often it is helpful to review some of the disastrous consequences that may result where no Buy-
Sell Agreement is in place. Regardless of whether the business operates as a corporation,
partnership or limited liability company, in the absence of a formal written agreement among the
owners, North Carolina State law will determine the parties' relative rights to share in the future
success of the business venture.
A. The Buy-Sell Agreement will balance the competing objectives of the
business entity itself and the objectives of the individual owners. In most cases, business
owners will have two very significant, but competing, concerns with respect to their investment
in the business enterprise.
1. Assuring Continuity of Ownership in the Business Enterprise. First of
all, from the perspective of the business venture itself, the owners as a group will be very
concerned about insuring continuity of ownership of the underlying business. Not surprisingly,
therefore, the business entity itself will wish to restrict the individual owners' ability to transfer
or encumber their interests in the business enterprise in favor of third parties.
2. Providing Co-Owners with the Ability to Realize on Their Investment.
On the other hand, from the perspective of each individual owner of the business venture, the
individual owners themselves will wish to have some mechanism in place that will allow them to
cash-in or realize upon their investment in the business venture. Since it is always possible that a
co-owner may die, become disabled, or wish to withdraw, each business owner will want to
provide themselves with the ability to realize on what perhaps may be their most valuable
investment asset.
B. In the Absence of a Buy-Sell Agreement, North Carolina State Statutory Law
May Defeat The Parties' Objectives and Goals. However, in many cases, North Carolina law
may act to severely inhibit the business entity or the individual owners from accomplishing their
desires. Therefore, the purpose of the Buy-Sell Agreement is to address these competing
concerns, and achieve some balance between the interests of the individual owners and the
interest of the business entity itself.
1. North Carolina Corporations. For example, under North Carolina
corporate law, corporate shareholders are free to transfer or devise their corporate stock in the
absence of a contrary agreement among the parties. Therefore, without a restrictive Shareholder
Agreement in place, the corporation has no way to insure continuity of corporate stock
ownership.
On the other side of the coin, however, North Carolina law provides no ability to the
shareholders to force a buy-out of their corporate stock. Therefore, the individual shareholders
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of a North Carolina corporation, in the absence of a contrary agreement, may have no practical
ability to realize on their investment in the event of their death, disability or desire to withdraw.
2. North Carolina Limited Liability Companies. Under N.C.G.S. Section
57C-5-02, members of an LLC are free to assign their membership interests to third parties. In
addition, LLC membership interests may be subject to a charging order in favor of the judgment
creditors of the individual LLC members. N.C.G.S. Section 57C-5-03.
Under N.C.G.S. 57C-5-02, a Membership Interest is assignable, but the assignment only
gives the transferee the right to receive distributions from the LLC. Thus, the transferee does not
become a voting members unless and until the transferee is admitted as a member. N.C.G.S.
57C-5-04(a) provides that an assignee becomes a member (with voting rights) only if the
assignee meets the requirements set out in the LLC Operating Agreement. And, if there is no
LLC Operating Agreement in place that addresses transfers of membership interests, then the
transferee becomes a voting member only if all of the other members unanimously consent to the
transferee becoming a voting member. N.C.G.S. 57C-5-04(a)(2).
Also, under N.C.G.S. 57C-5-03, if a judgment is issued against an LLC member, then a
court may grant the judgment creditor a "charging order" against that Member's LLC interest
which entitles the judgment creditor to receive the debtor/member's share of cash distributions
from the LLC, but no voting rights.
Thus, assignees and judgment creditors of a member are not entitled to become a
member, or to exercise the voting rights of any member. Nevertheless, the possibility of
assignment of a membership interest can create a great deal of uncertainty for the continuing
owners.
On the other hand, Members of an LLC are not permitted to voluntarily withdraw from
the LLC, unless withdrawal is specifically allowed pursuant to the terms of an Operating
Agreement among the LLC members. N.C.G.S. Section 57C-5-06. Furthermore, the withdrawal
of an LLC member will not cause the dissolution of the LLC, unless, once again, there is a prior
agreement among the parties which would require the LLC to dissolve. N.C.G.S. Section 57C-6-
01.
As a result of these provisions, in those cases where there is an LLC Operating
Agreement which prohibits assignments of membership interests, or which does not allow an
LLC member to voluntarily withdraw from the LLC, the individual LLC member will be unable
to liquidate and recognize upon their investment.
Accordingly, for a North Carolina LLC, Buy-Sell Agreements are critically important to
assure continuity of ownership and to ensure that the members will have some type of exit
strategy for withdrawing from the business.
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3. North Carolina General Partnerships. In general, assignees of a
general partnership interest do not become general partners in the partnership. N.C.G.S. Section
59-57. Thus, the assignee is not permitted to participate in management or even require any
information or accountings regarding partnership transactions. Instead, the assignee is entitled to
receive only his share of partnership profits that the transferor was entitled to receive. N.C.G.S.
Section 59-57. Likewise, judgment creditors of a general partner only acquire the rights to
receive partnership profits from the debtor-partner. N.C.G.S. Section 59-58. Therefore, in most
cases, the general partnership itself is protected from voluntary or involuntary transfers of
general partnership interests.
Nevertheless, under North Carolina law in the absence of a contrary agreement among
the partners, a general partnership will be dissolved and liquidated:
(i) At the will of any general partner; or
(ii) Upon the death or bankruptcy of a general partner.
N.C.G.S. Section 59-61.
Therefore, although general partnership interests are not freely transferable as such, a
North Carolina general partnership will not be protected from dissolution.
4. North Carolina Limited Partnerships. The North Carolina Uniform
Limited Partnership Act provides a great deal of protection to the limited partnership entity in the
event of the death of a limited partner or an assignment of a limited partnership interest. In
general, general and limited partnership interests are transferable and may be subject to judgment
creditors. N.C.G.S. Section 59-702 and 59-703. If there is an assignment of a general or limited
partnership interest, then the assignee may only become a limited partner if the other partners
agree or if the partnership agreement permits the assignee to become a limited partner. N.C.G.S.
Section 59-704(a).
Once again, however, the effect of these provisions is that limited partners are virtually
powerless to realize on their investment in a limited partnership. Thus, it may be impossible to
attract limited partnership investors without some partnership agreement provisions which would
allow limited partners to cash in on their investments in the event of their death, disability or
their desire to withdraw.
C. Summary. As indicated above, the application of North Carolina statutory law
will have varying effects on the business venture and its owners in the absence of specific buy-
sell provisions in a formal written agreement. This is specifically the reason that Buy-Sell
Agreements are so important in business planning.
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II. Structuring the Buy-Sell Agreement.
In structuring the terms of the Buy-Sell Agreement, at least six (6) important issues must
be addressed. Regardless of whether the business is owned by related or unrelated parties, and
regardless of the form of the business enterprise, the following questions must be answered:
1. What events will trigger a buy-sell option or obligation?
2. Under what circumstances will the sale/purchase obligation be voluntary
or mandatory?
3. How will the purchase price be determined?
4. What will the payment terms be under the buy-out?
5. Who will be designated as the purchaser under the buy-out: the
continuing owners or the business enterprise itself?
6. What other management or operational provisions, if any, will be present
in the Buy-Sell Agreement?
Throughout the rest of this paper, we will examine the various alternatives for structuring
the Buy-Sell Agreement and the different considerations which must be addressed in determining
the proper structure of the Buy-Sell Agreement.
III. Events Triggering the Buy-Sell Option/Obligation.
A. In General. In the context of any closely-held business (whether among related
or unrelated owners), it is essential that the business owners provide for the orderly continuation,
or, if appropriate, the buy-out of a disassociated equity owner or the dissolution of the business,
upon the occurrence of one of the following four "Big D's":
1. Death;
2. Disability;
3. Default; or
4. "Divorce".
The existence of a Buy-Sell Agreement will benefit both the individual owners as well as
the business itself in the event of the occurrence of one of the four "Big D's". In the case of the
first two "Big D's" referred to above, death and disability, it is easy to see why a Buy-Sell
Agreement is important.
In the case of the latter two "Big D's", additional clarification is necessary. As will be
discussed later, in the context of closely-held businesses, the business owners may set forth and
enumerate various types of events which will constitute a "default" by one of the business
owners.
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Moreover, when we refer to "divorce" in the context of a Buy-Sell Agreement, we are not
speaking only of the termination of the marital relationship of one of the business partners and
his/her spouse. We are also specifically addressing the possibility that a business owner may
become "divorced" from the business enterprise. A properly drafted Buy-Sell Agreement will
contemplate both types of "divorces".
B. "Mandatory" Versus "Optional" Buyout Provisions. In structuring a Buy-Sell
Agreement, there are basically three (3) buy-sell options available to the business enterprise and
the business partners:
1. Mandatory buy-sell obligations between the parties;
to the other business partners;
3. A "put" option which will require a purchase by the business enterprise or
the other business partners - thus allowing a withdrawing owner or his estate to force a buy-out.
As we will see, the selection of one of the three buy-sell options will vary depending
upon which of the four "Big D's" are at issue.
C. Death. Most Buy-Sell Agreements will provide for a mandatory buy-sell
obligation/option with respect to the business interest owned by a deceased business partner.
1. Advantages to the Deceased Owner’s Estate. A mandatory buy-out
"obligation" at death will benefit the deceased owner's estate in several ways:
a. Provides a Ready Market. First, since the Buy-Sell Agreement
will identify a specific purchaser of the ownership interest of a deceased owner, a ready
market will be created for the deceased owner's interest.
b. Providing Liquidity. Where the Buy-Sell Agreement mandates
the purchase of a deceased owner's interest, the Buy-Sell Agreement will provide the
estate with liquidity to pay estate expenses (death taxes, debts and administration
expenses) and to support surviving heirs.
c. Guaranteeing a Fair Price. The existence of a Buy-Sell
Agreement obligation at death also will enable the estate to obtain a fair price for the
business owner's interest. Since the Buy-Sell Agreement usually will provide a specific
mechanism for determining the buy-out price, the estate will not be forced to negotiate
price and payment terms from an unfavorable bargaining position.
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2. Advantages to the Continuing Business Owners. From the perspective
of the business enterprise and the continuing owners, a mandatory buy-out "option" also will
benefit the continuing owners:
a. A mandatory buy-out will allow the surviving business owners to
avoid interference by the deceased business partner's estate (or attorney) in the affairs of
the business;
b. A mandatory buy-out may eliminate potential friction between the
business (or surviving owners) and the deceased owner's estate since the purchase price
and payment terms will be predetermined; and
c. It usually is relatively easy to plan for a buy-out obligation at death
through adequate life insurance.
D. Disability. In the event of the disability of a business owner, the business
enterprise, as well as the disabled owner, may benefit from the existence of a Buy-Sell
Agreement providing for a buy-out in the event of disability.
1. Advantages to the Disabled Owner.
a. Disability Funding. From the disabled owner's perspective, a
buy-out will generate liquidity to support the disabled owner (since the disabled owner
would no longer be able to draw a salary or earnings from the business entity).
b. Ensuring a Ready Market and a Fair Price. Because closely-
held business interests are usually unmarketable, the existence of a Buy-Sell Agreement
will provide a ready market for the business interest of a disabled owner, and presumably
at a fair price.
2. Advantages to the Continuing Business Owners. From the perspective
of the business enterprise and the continuing owners, a buy-out will be appropriate since the
disabled owner, arguably, will no longer be able to contribute to the success of the business.
So, the only question, therefore, usually is whether the buy-sell opportunity should be
3. Mandatory vs. Optional Buyouts at Disability. In most cases, the buy-
out in the event of disability would be structured as follows:
a. Partial or Temporary Disability. In the case of a partial or
temporary disability, the business enterprise and continuing owners usually will have an option,
but will not be obligated, to purchase the disabled owner's interest. In many cases, the option to
purchase will be exercisable only at the end of a specified waiting period. This provides the
disabled owner with an opportunity to return to work.
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b. Total or Long Term Disability. In the case of total or long term
disability, the disabled owner will likely face significant financial hardship. So, the Buy-Sell
Agreement often will grant a "put option" to the disabled owner in the event of "long-term"
partial disability or total disability. This "put option", which often is exercisable only after some
specified waiting period (for instance two to five years), gives the disabled partner a way to fund
his disability but, at the same time, will provide the business with an opportunity to plan for any
proposed purchase.
E. Default. Depending upon the nature of the relationship between the business and
its owners, the Buy-Sell Agreement may set forth certain "events of default" which will give rise
to a buy-sell option in favor of the business enterprise. For example, the following is a list of
such default events:
1. bankruptcy, insolvency or an assignment for the benefit of creditors;
2. attempted voluntary transfers to outside third parties;
3. transfers to divorced spouses; and
4. an event of fraud, misappropriation or embezzlement of the business funds
or assets by the business partner.
In the event of any of these events of default, the business enterprise should be given the
option, but not the obligation, to acquire the “defaulting” partner’s interest in the business. This
purchase option will allow the remaining owners to avoid involvement of creditors or the
bankruptcy trustee in the day-to-day affairs of the business. Therefore, the business enterprise or
nondefaulting partners should never be required to purchase the interests of a defaulting partner
in the event of a default.
1. Bankruptcy or Insolvency of an Owner. In most cases, the bankruptcy
or insolvency of an owner will trigger an automatic purchase option by the business or the
continuing business owners. Hopefully, this provision will allow the remaining owners to avoid
involvement of the bankruptcy trustee in the day-to-day affairs of the business.
2. Attempted Transfers of Business Interests to Third Parties. In order
to assure that business interests are not transferred to any outside parties, the Buy-Sell
Agreement typically will provide for a purchase option in the event that there is an attempted
sale or gift to a third party. These "transfer restrictions" typically will offer a "right of first
refusal" to the business and other owners.
3. Transfers to Spouses at Divorce. The business owners usually will want
to take some action to assure that a divorced spouse of a business owner will not acquire an
ownership interest in the business. Such a spousal transfer may occur voluntarily, or it may
occur involuntarily such as where there is a transfer pursuant to a court-ordered equitable
distribution or separation agreement. Typically, the Buy-Sell Agreement will grant the divorced
business owner a first option to purchase the business interest back from his or her ex-spouse. If
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the divorced owner does not exercise this purchase option, then the remaining owners or the
business enterprise itself will have an option (but not a mandatory obligation) to purchase the
ownership interests from the divorced spouse.
F. Events of "Divorce". As discussed above, the fourth big D, "divorce," does not
refer to the divorce of a business owner from his or her spouse. Instead, in the context of Buy-
Sell Agreements, a "divorce" among the business owners must also be contemplated.
A "divorce" among the business owners may be "voluntary" such as where the business
owners amicably decide to "part ways." Or, the "divorce" may be "involuntary" such as where
the employment of an owner is involuntarily terminated. The structure of the buy-sell provisions
will vary significantly depending upon the nature of the "divorce."
1. Retirement or Voluntary Termination of Employment. In the case of
the unexpected retirement or voluntary termination of a business owner, the business enterprise
usually will not be obligated to immediately purchase the interest of the withdrawing partner.
This protects the business from having to fund an unexpected buy-out created by the sudden
"walk-out" of a partner. Instead, the business enterprise usually is given the option to purchase
the interest of the withdrawing partner.
On the other hand, to protect the interests of the withdrawing partner (and to allow an
opportunity for funding retirement), the withdrawing partner may be given a "put right" to
require a purchase after a suitable waiting period (once again, two to five years). This should
allow the withdrawing business owner to realize on the value of his investment in the business
but should not cause any undue economic strain on the business.
2. Involuntary Termination of Employment. Where there is an
involuntary termination of employment, the business enterprise usually is given an option to
purchase the terminated owner's interest. If the termination is "without cause", then the
terminated owner may be given a "put right" to require a buy-out of his interest; but often, this
"put right" will not be exercisable until some future time. However, if the termination is "for
cause", then the terminated employee-owner will have no "put right" option.
3. Deadlock. If the business enterprise has equal partners, then it is essential
to make provision for what should happen if the partners can no longer get along or are in a
deadlock as to the direction of the business. The Buy-Sell Agreement should therefore contain a
provision that gives any business partner the right to announce to the other partners his election
to either (i) buy the interests of the other partners or (ii) require the other partners to purchase his
interest. The other partners can elect either (i) to sell their interests to the announcing partner or
(ii) to purchase the announcing partner's interest.
Often times, the Buy-Sell Agreement will provide that the price and payment terms for a
purchase or sale will be set forth in the announcement notice. In order to "even up" any
difference in economic resources among the partners, the Buy-Sell Agreement will usually allow
the other partners a period of time in which to make their election. This will allow the "weaker
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partner" to either put together a financial package or to find a new partner to take the place of the
unhappy partner.
This type of arrangement sometimes is called the "Texas shoot out." Carolyn T. Geer,
"Prenuptial for Business Partners," Forbes (December 5, 1994).
IV. Establishing the Purchase Price.
A. In General. One of the most difficult decisions to reach in structuring a Buy-Sell
Agreement is the method or formula for determining the purchase price of the interest to be
bought or sold.
Without the existence of a Buy-Sell Agreement, the establishment of a purchase price
would likely be the most fiercely debated aspect of a buy out. However, because the Buy-Sell
Agreement usually will specifically set forth the method for determining the purchase price, the
existence of a Buy-Sell Agreement may serve to avoid future disputes since the owners will have
agreed upon a valuation method prior to the specific identification of the purchasers and sellers.
In the context of a family owned business, the purchase price component of a Buy-Sell
Agreement may have very significant income and estate tax ramifications. As will be discussed
later in this paper, in the context of S corporations, the purchase price component of a buy sell
agreement may affect the preservation of the company’s S Election where the Buy-Sell
Agreement is used to ensure a ready market for the S corporation’s stock held by an investor.
Likewise, as we’ll also discuss, for estate planning purposes, a Buy-Sell Agreement may
"fix" the estate tax value of a business owner's interest in the business. Unfortunately, in many
cases estate tax consequences are not considered when Buy-Sell Agreements are executed. As a
result, there may be missed opportunities to "freeze" the values of business interests for transfer
tax purposes. Likewise, the existence of the Buy-Sell Agreement may actually result in an
inflated business interest valuation.
And finally, the existence of the Buy-Sell Agreement may affect whether bequests of
stock to the deceased shareholder’s spouse will qualify for the marital deduction for estate and
gift tax purposes. And, the terms of the Buy-Sell agreement could also prevent gifts of business
interests from qualifying for the $13,000 annual gift tax exclusion.
These income and estate and gift tax issues will be discussed further below.
B. Alternative Valuation Methods. There are several alternative valuation methods
that may be used in a Buy-Sell Agreement. The following is a brief discussion of several
possible valuation methods.
1. Fixed Price Specified In the Agreement. The simplest valuation
method is to simply to provide for a buy-out price under the terms of the
agreement. The problem with this method, of course, is that the fixed price
should be adjusted to reflect increases or decreases in the value of the business.
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Therefore, most agreements incorporating a fixed price valuation method will
provide that the partners shall periodically review and redetermine the purchase
price. The new agreed upon purchase price will be incorporated into the Buy-Sell
Agreement and a "Certificate of Agreed Value" will be attached to the Buy-Sell
Agreement each year to be kept with the other records of the business.
Of course, an agreement among the business partners to redetermine the
purchase price each year is merely an "agreement to agree". As a result, the
partners may fail to redetermine the purchase price on a periodic basis. Thus, the
Buy-Sell Agreement should provide that, if the partners fail to execute a
Certificate of Agreed Value at least annually, then the most recent agreed value
will be adjusted based upon increases or decreases in book value, fair market
value or earnings of the business.
2. Book Value Method. Because most businesses prepare financial
statements based upon historical cost information, a book value method for
valuing business interests is another simple valuation method. Of course, because
book values are based upon historical costs less depreciation, the book value of
the business may not adequately reflect the true going concern value of the
business. Thus, most agreements which incorporate a book value methodology
will really use a "modified" book value method which will mandate that some
business assets be valued at their fair market value.
3. Valuation Based Upon Fair Market Values of Assets. The
principal advantage of the fair market value valuation method is that it avoids the
problems with historical cost valuation. On the other hand, the use of the fair
market value methodology will almost certainly necessitate the use of appraisers.
The agreement should specifically set forth the method for selecting the
appraisers as well as how their fees will be allocated among the partners.
4. Appraised Value of Business Interests. The Buy-Sell Agreement
may simply provide that a purchase price will be determined by an independent
appraiser. The agreement may specifically identify the appraiser or the method in
which the appraiser will be selected. Attention should be given to the necessary
qualifications of the selected appraisers and how the appraisal fee will be
allocated among the parties. The Buy-Sell Agreement also should specifically
address whether “minority interest” or “lack of marketability” discounts should be
taken to value the interests of the seller.
5. Capitalization of Earnings Method. Under this valuation
method, the value of the business is determined by multiplying the earnings of the
business by a capitalization factor. The value may be determined using the
business' most recent earnings or by using a weighted average of several years'
earnings. The problem with using the capitalization of earnings method is that
capitalization rates generally will vary among industries; thus, industry data
should be examined to determine the appropriate capitalization factor. Moreover,
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a capitalization of earnings method may yield an unreasonably high value for the
interests of a minority business owner unless minority interest and marketability
discounts are taken into consideration.
C. Selecting a Valuation Method - Summary. To select an appropriate valuation
method, the business owners should keep several points in mind. First of all, every business is
different and there is no one correct method for valuing the business.
For example, the value of fast food franchises typically are determined based upon a
multiple of gross income, while real estate businesses typically are sold based on the value of its
fixed assets. Manufacturing and retail businesses are typically sold on the basis of a multiple of
net earnings.
Whatever formula or method is adopted, several factors should always be considered:
(i) First, in setting the purchase price terms, the business owners should
assume that they will be purchasing rather than selling the business interest so as not to
overinflate the estimate of value.
(ii) Second, the business owners should consider the ability of the
business to pay the price established. It is not unusual for a buy-sell price to be
significantly less than the value the business would be offered to a third party
purchaser. The lower value reflects the enhanced risk to the remaining partners,
the increased cost of the deal to the remaining partners and the loss to the business
by the withdrawal or death of the partner.
(iii) A different or higher value may be used in the case of death
(covered by insurance) than would be used in the case of a default or voluntary
withdrawal by a partner (at a discounted or "penalty price").
(iv) The selection of the purchase price may have unexpected tax
consequences.
V. Establishing Payment Terms.
A. In General. The Buy-Sell Agreement should also specify how the purchase price
will be paid. In some cases, the Buy-Sell Agreement will provide for the payment of the entire
purchase price in cash. In most circumstances, however, the Buy-Sell Agreement will provide
that the purchase price will be payable partly in cash and partly by the issuance of an installment
promissory note. This will allow the purchasing entity to avoid having to go out and borrow
substantial amounts of money to fund the buy-out. This is very important in cases where it has
not been possible to fund the buy-out with other means either because of uninsurability or
because of insufficient opportunity to save sufficient assets for a buy-out.
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B. Typical Payment Terms. As discussed above, the payment terms should be
structured so as not to jeopardize the continuation of the business enterprise operation, yet,
remain fair to the selling business partner. The following are some considerations for
structuring the payment of the purchase price:
1. arguably, all insurance proceeds received by the business (or the
other owners) should be applied to the purchase price and paid lump sum to the
seller;
2. the balance of the purchase price, if any, should bear interest - but
the interest rate may be below or above the prime rate;
3. the balance, plus any interest, will be payable monthly or annually
over a term established by the business - but how long should the term be?
4. there may be a minimum monthly or annual installment amount to
provide a minimum level of income to the selling owner; and
5. the agreement may "cap" the required installment amount if corporate
earnings or cash flow fail to reach a certain level.
Note that the Buy-Sell Agreement could provide for a longer payout of the purchase price
if there is a "default" by the selling owner, if a "divorce" event has occurred or if the former
business partner has elected to compete with the business enterprise. A low interest rate or a no
interest rate deal can be imposed as a "penalty" for competition with the business or a default by
the withdrawing partner.
VI. Methods of Funding the Buy-Out.
A. In General. As soon as the Buy-Sell Agreement has been drafted, the parties
should also give due consideration as to how a buy-out would be funded in the event of a buy-out
event.
From the perspective of a selling owner, the Buy-Sell Agreement will have very little
intrinsic value unless the purchasing parties have the ability to fulfill their buy-out obligations.
From the perspective of the potential buyers, an unexpected buy-out event could place
significant financial hardships upon the remaining buying partners.
Moreover, after the occurrence of a buy-out event, there becomes an increased need to
fund additional buy-outs. This is because once there has been a buy-out event, each business
owner will then own a greater proportional interest in the business enterprise. Therefore, more
funds will be necessary in future years to fund each subsequent buy-out.
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B. Funding Mechanisms. In most cases, there are only three possible options for
funding a buy-out:
1. Financing the Purchase. If the business or the continuing owners do not
have sufficient cash to fund a buy-out, the purchasing parties may look for financing. As
discussed, the Buy-Sell Agreement will often provide for the payment of the purchase price over
a number of years in certain events (such as a default or divorce event). In these cases, where the
purchase is seller-financed, the corporate stock will often be pledged as collateral.
Outside financing is usually much more difficult to locate. The problem with third party
financing is that the business may have very little collateral to use as security for the debt.
Furthermore, a third party lender may have deep reservations about the credit worthiness of the
business after the occurrence of the death or withdrawal of one of the business owners. In light
of these concerns, the personal guarantees of the continuing business owners may not even be
sufficient security for third party lenders.
2. Use of a Sinking Fund.
a. Advantages. If the business owners plan far enough ahead into
the future, they may be able to establish a sinking fund for an eventual buy-out.
Indeed, when compared to an investment in life or disability insurance, an
investment in a sinking fund may yield a greater return on the investment. In
addition, where one or more business owners are uninsurable, the use of a sinking
fund may be the only available method to fund a buy-out.
b. Disadvantages.
(i) Premature Death or Disability. The principal disadvantage of
the sinking fund method is that there is always the risk of a premature death or
disability. Thus, the potential seller, as well as the potential buyer, may be
disadvantaged by the use of a sinking fund.
(ii) Cash Flow Consideration. Moreover, the establishment of a sinking
fund may be quite a drain on the cash flow of the business enterprise or its owners.
(iii) Accumulated Earnings Tax Problems. As discussed in Section
VII (B)(2)(e) below, the use of a sinking fund may also trigger the accumulated
earnings tax for C corporations.
(iv) Corporate State Law Insolvency Limitations. Finally, the
corporate law of some states may prohibit a corporate redemption if certain
solvency tests are not met. See for example N.C.G.S. Section 55-6-40(c).
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3. Use of Disability and Life Insurance. The use of disability and life
insurance is the most popular funding mechanisms, except in those cases where the owners are
uninsurable. Although an investment in life and disability insurance may produce a lower
investment yield than would the sinking fund alternative, the use of insurance insures against the
greatest disadvantage of the sinking fund method: that is, the possibility of a premature death or
disability. Also, if a life insurance policy product is utilized that accumulates cash value, the
cash surrender value may be used to fund the retirement of a retiring owner.
VII. Identifying the Purchaser Under a Buy-Sell Agreement.
A. In General. In structuring a Buy-Sell Agreement, appropriate consideration must
be given to the identification of a purchaser in the event of a buy-out of an interest in the
business. In this regard, there are only two possible purchasers: the remaining owners and the
business enterprise. Thus, most Buy-Sell Agreements fall into one of the following three
categories:
1. Entity Redemption Arrangement. In an entity redemption arrangement,
the business enterprise redeems the sold interest.
2. Cross-Purchase Arrangement. In a pure cross-purchase arrangement,
the remaining business owners will purchase the interest of a withdrawing business partner.
3. Hybrid Arrangement. With the hybrid arrangement, the business
enterprise and the remaining owners will be potential purchasers of a sold interest. In most
cases, the remaining owners are given the first option to purchase an outgoing partner's interest.
If the remaining owners fail to exercise their purchase options, then the business enterprise will
then have the option (or obligation) to purchase the business interest.
In deciding between the entity redemption method, cross-purchase method or a hybrid
method, many tax and non-tax considerations must be addressed.
B. Entity Redemption Arrangement.
1. Advantages.
a. Use of Business Funds. Under the entity redemption method, the
funds of the business enterprise are used to purchase the outgoing partner's interest or to pay
premiums on the disability or life insurance policies. From the perspective of the business
owners, the primary advantage of the entity redemption method is that the individual owners do
not have to rely on each other's ability to fund a buy-out. In addition, the individual owners will
not be primarily liable for the purchase obligation.
b. Simplification of Insurance Plan. Where the proposed buy-outs
will be funded with insurance, the primary advantage of the entity redemption arrangement is
that only one life insurance and disability policy must be taken out for each individual partner.
As will be discussed later, with the cross-purchase arrangement, each individual partner must
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take out disability and life insurance policies on each other. This greatly increases the number of
total policies which must be taken out in order to properly fund the buy-out.
c. Entity Redemption May Provide A Current Tax Deduction For
LLC Members or Partnership Partners. In the event of a redemption of a partner or LLC
member, the redemption proceeds may be treated as either
(1) a "guaranteed payment";
(2) a distribution of partnership profits; or
(3) a liquidating distribution.
If part or all of the redemption proceeds are treated as a "guaranteed payment", the
continuing owners may be entitled to take a current income tax deduction for the guaranteed
payment amount. Examples of guaranteed payments include payments to the partners or LLC
members for services (salary) or for the use of capital (interest).
However, if the redemption is treated as a distribution of profits or as a liquidating
distribution, or if a cross purchase is used, the continuing partners or LLC members will not be
entitled to any current income tax deduction.
d. Payment of Life Insurance Premiums On Entity Owned
Policies. Amounts paid for life insurance premiums to fund a buy-out are not deductible to the
business entity or to the individual owners. In the case of a cross-purchase agreement, the
business entity may have to make distributions of income to allow the individual owners to pay
premiums on the life and disability insurance policies.
Therefore, under the Entity Redemption Arrangement, if a C corporation is in a lower tax
bracket than the individual owners, it would be less expensive to have the corporation pay non-
deductible premiums (since corporate distributions to the shareholders to enable them to pay the
life insurance premiums would be taxed at their higher individual rates). Of course, in the case
of S corporations, partnerships and limited liability companies, there is no tax rate differential
problem.
2. Disadvantages.
a. Corporate-Owned Investment Assets and Life Insurance
Policies are Subject to Claims of Creditors.
b. Possible Dividend Treatment. If the enterprise is a family owned
C corporation, the redemption arrangement may result in a corporate redemption being
characterized as a taxable dividend as opposed to a sale or exchange of a capital asset. This issue
will be discussed further below.
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c. Income Tax Basis Considerations. Also, as we’ll discuss later,
the distinction between the Cross Purchase Arrangement and the entity redemption arrangement
will affect whether the continuing shareholders will be able to secure an increase in their tax
basis of the closely-held business interests. Generally, the main advantage of the Cross Purchase
Arrangement over the Entity Redemption Arrangement is that the purchasing shareholder under
the cross purchase arrangement always gets a basis step up. The same is not true in the case of
the Entity Redemption Arrangement.
d. Alternative Minimum Tax Consequences. When life insurance
is owned by a C corporation to fund a buy-out, the life insurance proceeds may be subject to tax
as a result of the alternative minimum tax provisions of the Internal Revenue Code. In the case
of S corporations, partnerships or limited liabilities companies, there is no alternative minimum
tax issues since life insurance proceeds do not generate alternative minimum tax for individuals.
e. Accumulated Earnings Tax. In cases where a C corporation
funds a buy-out through a sinking fund method, there may be accumulated earnings tax
consequences. Under IRC §531, an accumulated earnings tax of 15% is assessed on the
accumulated earnings and profits of a C corporation in excess of the amount required for the
normal operating expenses of the business. Depending upon the circumstances, the
accumulation of funds for the buy-out of a business owner may or may not be considered a
reasonable need of the corporation. Thus, the possibility of the accumulated earnings tax is
somewhat of a disadvantage of the entity purchase arrangement.
f. Inequality of Premium Payments. In cases where business
owners are of different ages or different insurability levels, there may be some inequities among
the owners depending upon whether a cross-purchase or entity redemption method is chosen. In
the case of a redemption agreement, the majority owner essentially will be funding his own buy-
out through the payment of premiums at the entity level. On the other hand, if a cross-purchase
method is selected, a younger (more insurable) or minority owner will have to pay a greater
premium on the policies insuring an older or majority owner.
g. Shift in Ownership Percentages. The Entity Redemption
Arrangement may also cause a shift in proportional ownership interests of the remaining
business owners. For example, assume that Father and Son each own 30% of the outstanding
stock of XYZ Company. Shareholder A owns the remaining 40%. If all of Father's share of
stock in XYZ Company are redeemed, then, after the redemption, Shareholder A will end up
owning 57% of the outstanding stock in XYZ Company (40%/70%). Son will own the
remaining 43%. As a result of the entity redemption in this case, control of XYZ Company has
shifted from Father and Son to Shareholder A.
This is another major disadvantage of the Entity Redemption Arrangement.
h. Increase In Entity Value. If a redemption is funded by life
insurance proceeds, the insurance proceeds will constitute an asset of the entity. In the case of a
deceased owner, the life insurance proceeds may increase the value of a deceased owner's
interest in the business absent a provision in the Buy-Sell Agreement specifically stating that life
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insurance proceeds are not taken into consideration in valuing the deceased owner's interest.
Once again, without careful planning, this is another disadvantage of the entity repurchase
arrangement.
i. Application of State Law. The corporate law of some states may
prohibit the business entity from purchasing ownership interests of its members if the redemption
would render the business entity insolvent as a result of the redemption. See N.C.G.S. §55-6-
40(c).
j. Possible Application of FASB 150. In May 2003, the Financial
Accounting Standards Board issued FASB 150 which requires that certain “mandatorily
redeemable financial instruments” be classified as liabilities for GAAP purposes under FASB
150. “Mandatorily redeemable financial instruments” include shareholder stock redemption
agreements. Taken literally, FASB 150 would require that any corporation, with a shareholder
stock redemption agreement, would have to book a liability, under its GAAP financial
statements, for the amount of contingent liabilities which might arise in the future, if the
corporation is required to purchase the stock of a shareholder.
The issuance of FASB 150 created a great deal of concern for closely-held businesses
that issue GAAP prepared financial statements. Clearly, FASB 150 would produce disastrous
financial reporting obligations for any closely-held business which would be required to convert
a portion of its shareholder equity into a balance sheet liability for contingent liabilities under its
stock redemption agreements.
Fortunately, in November 2003, FASB issued FASB Staff Position 150-3 which
indefinitely delays the application of FASB 150 to stock redemption agreements which provide
for mandatory redemptions of stock upon cessation of employment due to termination, death or
retirement. Thus, for our closely-held business clients, FASB 150 will not now apply to
redemption agreements. However, when we structure buy-sell agreements, we must be
concerned about whether (or when) FASB 150 would become applicable to mandatory
redemption agreements for non-SEC registered businesses.
Note: In light of potential application of FASB 150, some closely-held
businesses are converting their traditional entity redemption agreement to a
primary cross purchase arrangement which provides for an entity redemption only
if cross purchase options are not exercised.
k. Other Considerations. In some cases, the terms of loan
agreements may restrict the entity's ability to redeem an owner's ownership interest. Moreover,
if the entity incurs a debt in order to acquire an ownership interest, this debt on the books of the
business entity may inhibit its future ability to borrow money. These are major disadvantages to
the entity repurchase arrangement.
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C. Advantages and Disadvantages of the Cross-Purchase Arrangement.
1. Advantages. The primary advantage of the Cross Purchase Arrangement
is that it avoids many of the tax disadvantages of the entity purchase arrangement. For instance,
with the cross-purchase arrangement, there are no alternative minimum tax or accumulated
earnings tax concerns. Furthermore, with a cross-purchase arrangement, capital gains
recognition on the sale of a business interest will always be assured. In addition, there are other
tax advantages with the cross-purchase arrangement.
a. Tax Basis Increases. The primary advantage of the cross-
purchase arrangement is that each purchasing shareholder will receive an increase in their tax
bases as a result of the purchase of a withdrawing partner's interest. In the case of C
corporations, this is a primary disadvantage of the entity purchase arrangement. In the context of
S corporations, however, this difference is not as significant where the entity buy-out is funded
by life insurance.
b. Capital Gain Recognition to the Selling Shareholder. The sale
of a selling owner's interest in a corporation to a continuing business owner will always produce
capital gain treatment to the selling owner. This is because the dividend equivalency test of IRC
§302 will not come into play in the context of a cross-purchase arrangement.
2. Disadvantages.
a. Issuance of Multiple Policies. The primary disadvantage with the
cross-purchase arrangement is the administrative difficulty where a buy-out will be funded by
insurance. In the case of a cross-purchase arrangement, each shareholder will be required to own
insurance policies on each other shareholder. Thus, the total number of policies required for a
cross-purchase arrangement can be calculated using the following formula:
N x (N-1)
where N equals the number of owners of the business.
Thus, where there are five business owners, 20 insurance policies would be necessary to
fund a cross-purchase arrangement [5 x (5-1)].
b. Individual Responsibility For Funding Buy-Outs. Another
disadvantage of the cross-purchase arrangement is that each individual business owner must rely
on the other business owners' abilities to fund a buy-out. Also, each purchasing owner will face
individual liability for the buy-out obligation.
D. The Use of the Hybrid Arrangement. As discussed above, with the hybrid
arrangement, the tax advantages of a cross-purchase arrangement are combined with the non-tax
advantages of an entity purchase arrangement. The hybrid arrangement is essentially a "wait and
see" approach in which the business entity and the remaining owners are all designated as
possible purchasers of a business interest. Thus, the business owners can allocate the
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responsibilities for maintaining insurance policies among the business owners and the business
entity. In the event of a buy-out, the business owners can decide whether a purchase by the
business entity or the individual owners would be most advantageous from a tax planning
standpoint.
VIII. Other Buy-Sell Provisions.
A. Introduction. In addition to containing transfer restrictions and provisions for
the buy-out of ownership interests, the Buy-Sell Agreement may also address other management
and operational issues of the business. Some of these additional provisions will be designed to
benefit both majority and minority business owners. However, in many cases, these buy-sell
provisions will address certain issues of great significance to the minority owner. In fact, in
many cases the specific provisions will be necessary in order to attract minority interest
investors. The following is a discussion of some of these issues that may be addressed in a Buy-
Sell Agreement.
B. Compensation and Dividend Payment Policies. In order to protect the interests
of minority business owners, the Buy-Sell Agreement may contain provisions which limit the
payment of compensation to majority owner-employees. This would prevent the majority
owners from syphoning out business profits through excessive compensation.
Likewise, in the case of corporate Buy-Sell Agreements, the minority shareholders may
require a formal agreement setting forth the dividend policy of the company. In the case of an S
corporation, the shareholder agreement may mandate the payment of annual dividends to allow
shareholders to pay income tax on their share of S corporation income. Or, in the case of C
corporations, a minority shareholder may negotiate a dividend policy which insures that he or
she will receive dividend distributions in proportion to the dividend amounts paid to the majority
shareholders.
C. Minority Participation in Management. In order to assure that a minority
owner is guaranteed a management position within the business, the Buy-Sell Agreement may
contain a provision requiring that all owners vote their interests so as to insure representation of
the minority owners on the management team.
D. Put Options For Minority Owners. To provide minority owners with a ready
market for their business interests and a way to cash out their investment, prospective investors
will often require that they be granted some sort of put option to insure that they will always be
able to cash out their investment.
E. Arbitration Provisions. The Buy-Sell Agreement should always contemplate the
possibility that the business owners may become deadlocked in a disagreement over the
management of the business. Because civil litigation can be an extremely expensive (and
unfulfilling) experience, the Buy-Sell Agreement may provide for mandatory arbitration in the
event that a dispute should arise among the owners. Any such provision should specifically
address the method of selecting an arbitrator and how the arbitration fees will be allocated
among the parties.
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F. "Tag-along" Provisions. A Buy-Sell Agreement may also prevent a majority
owner from selling his interest to an outside purchaser unless the remaining owners are also
given the opportunity to sell their interests at the same price and on the same terms as are
applicable to the majority owner. This type of provision is called a "tag-along" provision which
is essentially designed to prevent a "squeeze-out" of minority owners.
G. Capital Calls and Contribution Obligations. If additional capital is needed in
order to fund business operations, a key question is where will the funds come from. Often, the
buy-sell agreement will obligate the owners to contribute additional operating capital. If any
owner fails to contribute additional capital, the buy-sell agreement may authorize a reallocation
of equity interest percentages, or the agreement may treat unfulfilled capital calls as a loan to the
defaulting partner.
H. Guaranty Provisions and Rights of Contribution. Frequently, one or more of
the equity owners will be required to personally guarantee some obligation of the business
enterprise. In the absence of a contribution provision in the buy-sell agreement, controversies
may arise where less than all of the owners are required to pay off a guaranteed obligation.
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PART TWO:
A REVIEW OF SELECTED TAX ISSUES
APPLICABLE TO S CORPORATIONS
I. Preserving S Corporation Status
A. S Corporation Status Provisions. The Buy-Sell Agreement of an S corporation
should always prohibit the transfer of S corporation stock to ineligible S corporation
shareholders in order to preserve the company's S corporation status. Such a provision would
typically include language to the effect that any such transfer to an ineligible S corporation
shareholder would be void and of no effect.
B. The Effect of Shareholder Agreements on the Application of the “One Class
of Stock” Rules for S Corporations Under I.R.C. Section 1361(b)(1)(D), an S corporation may
have only one class of stock. Although an S corporation may have classes of stock which offer
differing voting rights, all classes of stock must confer identical rights to distribution and
liquidation proceeds. Reg. 1.1361-1(l)(1).
If an S corporation's Shareholder Agreement is not carefully drafted, the existence of the
Shareholder Agreement may violate the one class of stock rules. Under Section 1.1361-1(l)(2), a
Shareholder Agreement is a binding corporate agreement which must be reviewed to determine
whether all S corporation shares of stock confer identical rights to distribution and liquidation
proceeds.
For purposes of applying the “one class of stock” rules in the context of Shareholder
Agreements, the tax code regulations distinguish between Shareholder Agreement provisions
that contain buy-out provisions upon death, disability, termination of employment and divorce,
and those Shareholder Agreements which provide for buy-out opportunities upon any other
event.
1. Agreements Which Provide for Buyout in the Event of Death,
Disability and Termination of Employment or Divorce. As discussed above, many
shareholder agreements provide for varying buy-out prices, depending upon whether the buyout
occurs because of the death, disability, withdrawal or divorce of the “outgoing shareholder.” In
some cases, a Buy-Sell Agreement will provide for an increased purchase price in the event of
the death or disability of the Selling Shareholder. Generally, the increased purchase price is
designed to alleviate the cash-flow pressures which will befall the family of a deceased or
disabled shareholder. On the other hand, in some cases, a Buy-Sell Agreement will contain
“penalty provisions” which are designed to depress the purchase price where a buy-out is
triggered upon divorce or termination of employment.
Under the one class of stock rules, a Shareholder Agreement will be disregarded in
determining whether the S corporation has more than one class of stock unless:
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(i) a principal purpose of the agreement is to avoid the one class of stock
rules: and
(ii) the agreement establishes a purchase price that, at the time the
agreement is entered into, is significantly in excess or below fair market value.
Reg. 1.1361-1(l)(2)(iii).
Therefore, in most cases, a Shareholder Agreement will be disregarded in determining
whether an S corporation has more than one class of stock, to the extent that the buyout
provisions relate only to death, disability, termination of employment or divorce. Reg. 1.1361-
1(l)(2)(iii).
For example, assume an S corporation has a Shareholder Agreement in place which
provides for a depressed purchase price upon termination of employment. Under Reg. 1.1361-
1(l)(2)(iii)(B), these provisions will be disregarded in determining whether an employee's stock
is subordinate to other shares held by other shareholders.
Likewise, a shareholder agreement that provides for a buyout price upon death which is
substantially greater than the price offered to other shareholders would not be deemed to confer
preferred shareholder rights.
2. Other Buy-Out Events. On the other hand, in those cases where the
Buy-Sell Agreement addresses other buyout events (other than death, disability, termination of
employment or divorce), then these Buy-Sell Agreements will not be disregarded in determining
the one class of stock issue if:
(1) a principal purpose of the agreement is to circumvent the
one class of stock requirements; and
(2) the agreement establishes a purchase price that, at the time
the agreement is entered into, is significantly in excess of or below the fair market
value of the stock.
Please note that the Shareholder Agreement will fail to satisfy these rules only if it is
determined that the purpose of the buy sell agreement is to circumvent the one class of stock
rules, even if it is clear that the buyout price under the Shareholder Agreement differs
substantially from fair market value.
For example, assume that an S corporation enters into a Shareholder Agreement which
grants the other shareholders a purchase option in the event a shareholder should become
insolvent or make an assignment for the benefit of creditors. Also assume that the option price is
substantially below the fair market value of the stock at the time the agreement is entered into.
In this case, even though the buyout price differs substantially from fair market value, the
Shareholder Agreement in this case does not violate the one class of stock requirements, unless
it can be shown that the purpose of the agreement itself was to avoid the one class of stock rules.
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But don’t let these rules allow you to become too comfortable in structuring Buy-Sell
Agreements, because many traps await around the corner.
For example, in many cases, an investor-shareholder will wish to enter into a Shareholder
Agreement, prior to investing, to assure the investor that he or she will be able to realize on his
investment at some point in the future. In these cases, the structure of the Buy-Sell Agreement
may jeopardize the S corporation status.
EXAMPLE: In 2007, S Corporation offers to issue stock to an investor at an
issue price of $10.00 per share which is roughly equal to the fair market of the
stock at the date of issuance. Upon investment, S Corporation enters into a
Shareholder Agreement with the investor which will give the investor a "put"
option to require the corporation to buy back the investor's shares at the expiration
of an initial five year period, at a put price of $100.00 per share.
Five years later, the IRS asks to review the company’s Shareholder Agreement to
determine whether the Agreement violates the “one class of stock” rules. At the
time of the audit, the fair market value of the stock is $100.00 per share, which is
equal to the buy-out price under the Shareholder Agreement.
In this case, the put price under the Shareholder Agreement substantially exceeds
the fair market value of the stock at the date the agreement was entered into.
In addition, since the purpose of the Shareholder Agreement was to provide the
investor with a ready market for his stock, the IRS may succeed in concluding
that a principal purpose of the Shareholder Agreement was to avoid the one class
stock rules.
II. Income Tax Allocations for S Corporation Buy-Outs.
In structuring the terms of Buy-Sell Agreements for S corporations, the parties should
specifically provide for allocation of income and loss items in the event of a future stock buy-
out. The S corporation shareholders should remember that, in the event of a buyout of S
corporation stock, the allocation of S corporation income and loss items during the year of the
buy-out will affect:
The income tax liabilities of the selling and continuing shareholders.
Whether S corporation distributions during the tax year will be treated as taxable
dividends to the shareholders.
The determination of the selling shareholder’s tax basis in the sold S corporation
stock.
The calculation of tax basis for the continuing shareholders .
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EXAMPLE: ABC, Inc. is an S corporation with 2 shareholders, X and Y. On June 30,
2012, X purchases all of Y’s stock in ABC, Inc. pursuant to the terms of the company’s
shareholder agreement. As of June 30, ABC, Inc. has incurred net operating losses of
$100,000. Prior to the buy-out, ABC, Inc. made S corporation distributions to X and Y.
During the remainder of 2012, ABC, Inc. recognized $300,000 in profits and made
additional S corporation distributions to X.
Consider what effect the buy-out will have on the tax liability of X and Y during 2012
under the general S corporation income allocation rules.
Under the general S corporation income allocation rules, X and Y will be allocated
income and losses on a per-share per-day basis, which means that Y will be allocated $50,000 in
S corporation taxable income for the year (taxed at ordinary income tax rates), and X will be
allocated $150,000 in taxable income.
These general income allocation rules will also affect:
The calculation of Y’s tax basis in his ABC, Inc. stock, and thus the amount of
taxable gain he is required to recognize on the sale to X;
X’s end of the year tax basis in his ABC, Inc. stock; and
If ABC, Inc. has accumulated E&P from previous C corporation tax years,
whether X or Y (or both of them) will be taxed on the ABC, Inc. distributions
they received during the year.
Therefore, in this case, it may be “fairer” for the parties to make an election to terminate
the tax-year of ABC, Inc. and treat ABC, Inc. as having 2 separate tax years. (See Section 1377).
If such an election were made, Y would be allocated $50,000 in losses, and X would be allocated
$50,000 in losses and all of the $300,000 income.
Therefore, whenever an S corporation is involved, the parties to the Buy-Sell Agreement
should address if and when these such elections will be made.
III. Mandatory S Distributions to Cover S Corporation Tax Liabilities.
Since S corporation shareholders are required to pay income tax on their distributive
share of S corporation income, most S corporation Buy-Sell Agreements will mandate annual, or
perhaps quarterly, distributions to cover end-of-the-year and estimated tax payments. This
provision will protect minority shareholders from having to pay income tax on “phantom” S
corporation income.
Warning! Beware of the “One Class of Stock” Rules! Any such mandatory
distributions should not be made with specific reference to each shareholder’s specific marginal
tax rates, because this arrangement could result in disproportionate distributions which could
result in the termination of the S election, if the shareholders are subject to differing marginal tax
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rates. Instead, the Buy-Sell Agreement should mandate distributions to all shareholders at the
highest combined federal and state marginal tax rate present among the shareholders.
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PART THREE
STRUCTURING BUY-OUTS USING REDEMPTIONS
VS. CROSS PURCHASE BUY-OUTS
I. In General.
Perhaps the most complicated (and often least understood) tax consideration in
structuring a buy-out is whether to structure a buy-out through a redemption versus a cross
purchase transaction. As discussed above, the Entity Redemption form of a Buy-Sell Agreement
is often easier to structure and administer than is the Cross Purchase arrangement.
The advantages of the Entity Redemption arrangement over the Cross Purchase
Arrangement are as follows:
1. Entity Buy-Out Obligation. The entity (rather than other owners) are
primarily responsible for fulfilling the buy-out obligation.
2. Simplification of Insurance Plan. The entity needs to maintain only one
insurance policy per owner.
The potential disadvantages of the Entity Redemption Arrangement, and hence the
advantages of the Cross Purchase Arrangement, are
1. Continuing owners usually receive no tax basis increase where entity
funds are used to fund a buy-out of the selling owner.
2. Possible dividend (rather than capital gain) treatment to the selling
shareholder where the redeeming corporation has accumulated earnings
and profits from C corporation tax years.
II. Income Tax Basis Considerations for the Continuing Owners. The distinction
between the Cross Purchase Arrangement and the Entity Redemption Arrangement will affect
whether the continuing owners will be able to increase their tax basis of their closely-held
business interests upon the buy-out of another owner.
A. C Corporations. If a C corporation redeems stock of a withdrawing
owner, the remaining shareholders do not receive a "step up" in their tax bases as
a result of the redemption. At the same time, however, each remaining
shareholder's proportional ownership interest in the value of the business will
increase. If the remaining shareholders anticipate selling their stock before their
death, this income tax basis issue will be a major disadvantage of the Entity
Repurchase Arrangement.
B. S Corporations. In the context of S corporations, however, this
difference is not as significant where the entity buy-out is funded by life insurance
upon the death of the redeemed shareholder. The reason for this is that, in the
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case of S corporations, the receipt of life insurance proceeds will result in a basis
increase for each person who is a shareholder of the S corporation at the time the
S corporation accrues the right to receive the insurance proceeds.
Thus, if the S corporation is an accrual basis taxpayer, then part of the basis step-
up will inure to the benefit of the deceased shareholder. Nevertheless, the remaining S
corporation shareholders will receive some benefit from the basis increase from the life
insurance proceeds.
In the case of a cash basis S corporation which purchases the S corporation stock
of a deceased shareholder, the life insurance proceeds will result in a basis step-up only
for the surviving shareholders, as long as the buy-out occurs before the S corporation
receives the life insurance proceeds.
For example, in PLR 200409010, the IRS ruled that the redemption of a deceased
shareholder’s stock prior to the accrual basis corporation’s receipt of life insurance
proceeds and the corporation’s election to terminate the tax tear of death will not serve to
prevent the allocation of tax basis to deceased-selling shareholder. This PLR presents a
clever attempt to resolve problems presented by life insurance payable to an accrual basis
S Corporation. Under the facts of this ruling, an accrual basis S Corporation held a life
insurance policy on the life of a deceased shareholder.
In the PLR, the Corporation stated that it was planning to redeem the stock held
by the deceased shareholder by issuing to his estate a promissory note - prior to receipt of
the proceeds of life insurance or even prior to submission of a claim for payment of the
death benefit proceeds. In addition, after the redemption, the remaining stockholders
intended to make an election under IRS Section 1377 to terminate the corporation’s
taxable year to insure that, after termination of the corporation’s taxable year after the
redemption but prior to the submission of a claim on the life insurance policy, the
remaining stockholders could seek to have all of the insurance proceeds allocated to their
share of stock in the S Corporation.
The S Corporation, requesting the PLR, stated that the purpose of this PLR
request was to insure that the stock of the deceased shareholder would not be increased
by the amount of insurance proceeds that would have been allocable to his estate in the
absence of the closing of the S Corporation’s taxable year.
However, the IRS ruled in this case that, notwithstanding the S Corporation’s
intention to terminate the tax year prior to receipt of the death benefit proceeds or
submission of a death benefit claim, the full amount of the life insurance proceeds
received by the accrual method S Corporation would have to be allocated to all the
shareholders (including the decedent) based upon their stockholder interests as of the date
of death. This PLR makes it clear that, in cases where an entity redemption arrangement
is in place for an accrual basis S Corporation, a potential train wreck lies ahead.
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C. Partnerships and LLCs. In the case of partnerships and LLCs, an entity
redemption does not automatically allow the continuing owners to increase their
individual tax bases in their interests in the partnership or LLC. In the case of cross
purchase of partnership or LLC interests, there is an automatic increase in tax basis
without any affirmative action on the part of the partners or LLC members.
Where the LLC or partnership holds life insurance to fund a buy-out, the receipt
of life insurance proceeds will result in a tax basis increase for all persons who are
members of the LLC or partnership when the LLC or partnership accrues the right to
receive the insurance proceeds. Thus, in the case of an accrual basis LLC, part of the tax
basis increase will inure to the benefit of the deceased-selling LLC member. Likewise, in
the case of a cash basis LLC which receives life insurance upon the death of a member,
part of the basis will inure to the benefit of the deceased member, unless the buyout is
completed before the LLC receives the life insurance proceeds.
Also note that, regardless of whether there is an entity redemption arrangement or
cross purchase agreement, the continuing owners of an LLC or partnership should
consider the potential benefits of making a Section 754 election after a buy-out. If the
partnership or LLC makes a "Section 754 election", the partnership or LLC may be
allowed to increase the entity's tax basis in its assets if the outgoing partner or member
recognizes gain on the redemption. This will have the effect of reducing future
recognition of taxable gain to the continuing owners. The potential problem, however, is
that the entity must not fail to affirmatively and timely elect to make a Section 754
election to increase the entity's tax basis in its assets.
III. Dividend v. Capital Gains Treatment to the Redeemed Shareholder.
A. S Corporations with No C Corporation E and P. If a buy-out is
structured using the Entity Redemption Arrangement, and the redeeming corporation is an S
corporation with no accumulated C corporation E & P, the redeemed shareholder will recognize
capital gains to the extent the redemption proceeds exceed the selling shareholder’s tax basis in
the S corporation stock.
B. C Corporations and S Corporations with C corporation E & P.
However, if the redeeming corporation is a C corporation or an S corporation with C corporation
E & P, then the provisions of IRC Section 302 will apply to determine whether the redemption
will be treated as a dividend or as a capital gains transaction.
Under IRC §302(b), the redemption will qualify as a capital sale or exchange of a capital
asset if the redemption:
- effects a complete termination of the selling shareholder’s stock ownership;
- is "not essentially equivalent to a dividend". (A redemption will not be essentially
equivalent to a dividend if the redeemed shareholder's proportionate interest in the corporation is
less than 80% of his ownership interest before the redemption); or
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- constitutes a “substantial disproportionate redemption.”
However, if the redemption fails to qualify as a capital gains transaction under any of the
above referenced tests, then the redemption will be treated as a dividend which may produce
disastrous tax consequences to the redeeming shareholder.
C. The Family Attribution Problem For C Corporations and S Corporations
With Accumulated C Corporation E & P.
The problem here is that, in the family business context, the family attribution rules of
IRC §318 may apply whenever a family member's stock is redeemed. As a result of the
attribution rules, the redemption of a family member's stock may not constitute an adequate
reduction in the family member's interest in the business. This could cause a redemption to be
recharacterized as a dividend distribution.
As a result of the family attribution rules, an Entity Redemption Arrangement may be
inappropriate in the family business context for C Corporations and S Corporations with
accumulated C Corporation E & P, since any redemption could be recharacterized as a dividend.
D. A Case Study Example.
1. Fact Background.
Smith Co. is a family-owned S corporation which is owned by three individuals, Father
(60%), Son (20%) and Daughter (20%).
Son and Daughter acquired their stock ownership in Smith Co. from Father as part of
Father’s annual gifting program for estate tax avoidance purposes.
In 1997, Father decides to retire from Smith Co. At the time of Father’s retirement,
Father’s income tax basis in his stock is $100,000.
When Father announces his retirement, Son and Daughter agree to purchase Father’s
stock for $550,000 with $50,000 being paid to Father now and $500,000 paid over the
next 10 years.
At that time, Smith Co. has $550,000 in cash on hand (enough to purchase Father’s
stock). Smith Co. also has an accumulated adjustments account (AAA) of $50,000 and
has $300,000 of undistributed C corporation Earnings and Profits from pre-S election
years.
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2. How should this purchase be structured: through a Cross Purchase
Arrangement or by having Smith Co. redeem Father’s stock?
3. Father’s Tax Concerns.
Regardless of how the sale-purchase is structured, Father wants to ensure that his sale of
stock will qualify for capital gains treatment. This will allow Father to:
1. deduct his tax basis from the sales proceeds;
2. recognize postponed gain under the installment method; and
3. recognize capital gains at capital gains tax rates.
4. Tax Concerns of Son and Daughter.
Son and Daughter are concerned about how they will fund the 10 year purchase
obligation, and whether they will be able to increase their tax basis in their stock as payments are
made to Father.
Son and Daughter realize that if, an Entity Redemption Arrangement is used and
corporate funds are used to purchase Father’s stock, Son and Daughter may not be able to
increase their tax basis for the annual note payments, unless the note payments are made from
annual S corporation earnings which increase their stock basis from year to year.
On the other hand, Son and Daughter also realize that they may not have adequate means,
on their own, to purchase Father’s Stock under a Cross Purchase Arrangement. Therefore, if the
parties use a Cross Purchase Arrangement, Son and Daughter may have to use corporate
distributions to meet their annual purchase obligations. These annual distributions to Son and
Daughter will either be:
1. “Bonus” distributions which may be subject to payroll taxes;
2. S corporation distributions which may be treated as dividends if the AAA account
($50,000 now) is not sufficient to cover future annual distributions.
5. What options are available to Father, Son and Daughter?
6. Alternative One: Structure the Purchase as a Redemption.
If Smith, Co. redeems Father’s stock for $50,000 cash and a $500,000 note, this
redemption presumably would qualify for capital gains treatment under Section 302, since the
redemption would completely terminate Father’s stock ownership.
However, the family CPA advises them that the “family attribution” rules of Section 318
must be reviewed to determine whether a complete redemption of Father’s stock has occurred.
Under the general Section 318 parent-child attribution rules, Father will be deemed to own all of
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the stock then owned by Son and Daughter even after the redemption, and thus Father will not be
able to meet the “complete termination” requirement.
This means that, unless the family attribution rules can be avoided, Father’s redemption
will be treated as a dividend and not as a capital gain.
Fortunately, however, Father may be able to avoid the family attribution rules (and
accomplish a complete termination of his stock) if three requirements are met:
1. After the redemption, Father will have no interest in Smith, Co. other than as a
creditor.
2. Father will not acquire any interest in Smith Co. over the next ten years.
3. Father files an agreement with the IRS to notify the IRS if he acquires any interest
in Smith, Co. over the next 10 years.
I.R.C. 302(c)(2)(A).
But we are not out of the woods yet.
Even if Father meets all three of the above-mentioned family attribution rules, the parties
will not be able to “waive” family attribution if Son and Daughter have acquired their stock from
Father during the past 10 years in a “tax avoidance” transaction. I.R.C. 302(c)(2)(B)(ii).
Fortunately, however, the IRS in the past has ruled that prior gifts to children do not
violate the “waiver of family attribution” rules if the gifts were part of a plan to transition the
business to succeeding generations. Rev. Rul. 77-455; LTR 8637090.
Therefore, it appears that Father can achieve capital gains treatment through an Entity
Redemption Arrangement.
But will this address the tax concerns of Son and Daughter?
The answer to this question may be “no” since an Entity Redemption Arrangement may
not allow Son and Daughter to get any tax basis increase as future note payments are made to
Father unless these future note payments are made from annual corporation profits.
Therefore, in light of their concerns, Son and Daughter may have to structure the
purchase as a Cross Purchase Arrangement to ensure Son and Daughter that they will get to
increase their stock basis as payments are made to Father.
7. Structure the Purchase as a Cross Purchase
Under the Cross Purchase Arrangement, since Son and Daughter will be purchasing
Father’s stock directly, they will be able to increase their tax basis in their corporate stock as note
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payments are made to Father. Also, since Father will not receive any payments directly from
Smith Co., there is no danger that Father’s buy-out will be structured as a dividend, rather than as
a capital gains transaction.
However, whenever a Cross Purchase Arrangement is used, the issue arises as to how the
purchasers will be able to fund their purchase obligation.
In this example, if Son and Daughter do not have sufficient resources of their own to fund
the buy-out, they will have to withdraw funds from Smith Co. each year in order to meet their
annual payment obligations. These annual withdrawals will be treated:
- as non taxable dividends (if AAA is sufficient to cover their note payments to
Father); or
- as a bonus or loan (if AAA is not sufficient to cover their note payments to
Father).
The foregoing example is an adaptation of Case Study 12B found on page 12-31 of PPC Tax
Planning Guide - S Corporations (Practitioners Publishing Company).
IV. An Alternative Buy-Sell Arrangement For Corporations: The Life Insurance
Partnership.
A. In general. As discussed above, the primary disadvantage with a Cross Purchase
Arrangement is the administrative difficulty in maintaining multiple insurance policies on the
lives of each business owner. On the other hand, because of its tax disadvantages, the Entity
Redemption Arrangement may not be a suitable alternative to the Cross Purchase Arrangement.
This is especially true where C corporations are involved since most of the tax disadvantages of
the Entity Redemption Arrangement are uniquely applicable to C corporations (such as
alternative minimum tax, dividend/capital gain recognition and income tax basis considerations).
In fact, in light of these tax disadvantages, the hybrid arrangement may not be entirely
satisfactory either.
Therefore, in recent years a great deal of interest has arisen in the use of life insurance
partnerships.
B. The Life Insurance Partnership. A life insurance partnership is a partnership
among the business owners. The partnership would own the life insurance policies on each
partner-shareholder. At the death of the partner-shareholder, the partnership would use the life
insurance proceeds to purchase the deceased partner-shareholder's stock. The surviving partners-
shareholders would then acquire the deceased partner-shareholder's beneficial interest in the
policies insuring their lives.
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C. The Advantages of the Life Insurance Partnership. The advantages of the Life
Insurance Partnership over the Cross Purchase and Entity Redemption Arrangements are
obvious:
1. only one policy per owner is necessary;
2. a buy-out at death will always be treated as capital gain;
3. the surviving business owners get a "step-up" increase in tax basis.
4. potential “transfer for value” rules would be avoided since the deemed
transfer of life insurance policies would be deemed a transfer to the partners. Internal Revenue
Code Section 101(a)(2)(B).
Although there have been a few private letter rulings in this area, there is little authority
with respect to this technique, and each particular situation should be addressed carefully before
implementing a life insurance partnership.
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PART FOUR
ESTATE AND GIFT TAX CONSEQUENCES OF BUY-SELL AGREEMENTS
I. “Fixing” Estate and Gift Tax Values
A. In General. As discussed above, in the event of the death of a business owner,
the terms of the Buy-Sell Agreement may "fix" the estate tax value of a deceased owner's interest
in the business. Thus, in the context of a family business, the Buy-Sell Agreement may be
properly structured so as to "freeze" the value of the business interests for estate tax purposes.
On the other hand, if a Buy-Sell Agreement is prepared for a family business without appropriate
consideration to estate tax consequences, the deceased owner's estate may be burdened by an
inflated valuation.
The following is a discussion of the rules for “fixing” the estate tax value of business
interests through the use of a Buy-Sell Agreement.
As a result of IRC Section 2703, which was added to the Internal Revenue Code as part
of the Revenue Reconciliation Act of 1990, the rules for fixing estate tax values under Buy-Sell
Agreements will vary depending upon whether the agreement was executed before or after
October 9, 1990.
B. Pre-October 1990 Agreements. Reg. 20.2031-2(h) indicates that the existence
of a Buy-Sell Agreement may have an effect on the value of the business interests for estate tax
purposes. Under the relevant case law, a buy-sell arrangement will "fix" the estate tax value of a
business interest if the following four requirements are met:
1. Price. The buy-sell price must be fixed or determinable under the terms
of the agreement.
2. The Estate Must be Obligated to Sell. The estate must have been
obligated to sell at the fixed price under the terms of the Buy-Sell Agreement. Thus, if the
business or surviving owners are given options to acquire the interests of a deceased owner, this
usually will fix the estate tax value since the estate would be obligated to sell in the event of the
exercise of those options. See Estate of Carpenter, T.C. Memo 1992-653.
On the other hand, if the Buy-Sell Agreement merely gives the surviving owners a right
of first refusal, then this will not establish the estate tax value since the estate in that case is not
obligated to sell its interest in the business. Estate of Pearl Gibbons Reynolds, 55 T.C. 172
(1970). Of course, if the surviving owners have a right of first refusal, this may lower the value
of the business interest for estate tax purposes. See Reynolds, 55 T.C. 172 (1970); Worchester
County Trust Co. v. Comm'r., 134 F.2d 578 (1943).
3. Binding Obligation During Lifetime. The deceased owner's obligation
to sell at the buy-sell agreement price must be binding during his lifetime. Revenue Ruling 59-
60, 1959-1 C.B. 237. For instance, if a corporate shareholder, during his lifetime, was subject to
a right of first refusal to the corporation and the other shareholders who could elect to buy-out
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the selling shareholder’s stock at the lower of the price offered by the third party or the price set
out in the buy-sell agreement, then this would constitute a lifetime obligation which would “fix”
estate tax values. However, if the agreement does not restrict lifetime transfers but simply
provides for a buy out at death, then there will be no lifetime obligation to sell and thus the
agreement will not fix the estate tax values. See Harwood, 82 T.C. 239 (1984). Likewise, where
a shareholder, during his lifetime or at death, could transfer his stock to any person at any price
without first offering to sell his stock to the remaining shareholders, the buy-sell agreement did
not “peg” the estate tax values. Matthews v. Comm’r, 3 T. C. 525 (1944). In the case of
Obering v. Comm’r, since the buy-sell agreement did not prevent a transfer to another
shareholder during lifetime, the existence of the buy-sell agreement was one factor, but not a
determinating factor, to be considered in determining estate tax values. Obering, 48 T. C. M.
733 (1984).
4. The Buy-Sell Agreement Must be a Bona Fide Business Arrangement
And Not Merely a Device to Pass Interests to Family Members For Less Than Adequate
Consideration. In order to establish that the Buy-Sell Agreement is a bona fide business
arrangement, and not simply designed to pass assets to the next generation tax free, the terms of
the Buy-Sell Agreement should be established by negotiation among the parties, and the buy-out
price must be fair when the agreement is made. In addition, there should be substantial evidence
that the buy-out price was established based upon some reasonable means (through an appraisal,
based upon industry information, etc).
C. Buy-Sell Agreements Executed after October 1990 and Buy-Sell Agreements
Substantially Modified after October 1990. When IRC Section 2703 was added to the Internal
Revenue Code, a new set of rules became applicable to Buy-Sell Agreements executed after
October 1990, and to Buy-Sell Agreements executed before 1990 if there is a substantial
modification in the Buy-Sell Agreement after October 1990.
If a Buy-Sell Agreement was executed or substantially modified after October 1990, then
Section 2703 states that a Buy-Sell Agreement will not be determinative of the value of a
business interest for estate tax purposes unless all of the following three (3) requirements are
met:
1. The Buy-Sell Agreement must be a bona fide business arrangement;
2. The Buy-Sell Agreement must not be a device to transfer the business
interests to the decedent's heirs for less than full consideration; and
3. The terms of the Buy-Sell Agreement must be comparable to similar
arrangements entered into by persons in arms length transactions.
D. Final Points to note about Section 2703:
1. Section 2703 Exception for Unrelated Parties. Reg. 25.2703-1(b)(3)
provides that a Buy-Sell Agreement will be deemed to have met the three statutory exceptions to
Section 2703 if more than fifty percent (50%) of the value of the business is owned by unrelated
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individuals. Thus, if the business enterprise is not exclusively a family owned business, then
Section 2703 may not operate to prevent the terms of the Buy-Sell Agreement from fixing the
estate tax value.
2. Section 2703 Does Not Automatically Assure an Estate Freeze. Please
note that Section 2703 does not replace prior case law regarding the effects of the existence of
the Buy-Sell Agreement on the estate tax value. Thus, even if the agreement satisfies the three
requirements of Section 2703, the agreement still will not fix the estate tax value of the business
interest unless the other prior case law requirements (Section I (B) above) are met. See S.
Budget Comm., 101
st
Cong., 2d Sess., Informal Report on S. 3209, 136 Cong. Rec., S15,629,
S15,683 (Oct. 18, 1990) (indicating that the new Section 2703 would not otherwise alter
requirements for a buy-sell agreement, such as the requirement that it have lifetime restrictions in
order to be binding at death): See also Treas. Reg. 20.2031-2(h).
E. Gift Tax Consequences. The IRS generally takes the position that a Buy-Sell
Agreement will not "freeze" the value of corporate stock for gift tax purposes unless the
requirements of Section 2703 are met. Nevertheless, in prior cases, courts have held that the
existence of a Buy-Sell Agreement may have a depressing effect on the value of corporate stock
for gift tax purposes, especially where the transferred stock was subject to a Buy-Sell Agreement
which grants rights of first refusals in the event of an attempted subsequent sale of the gifted
stock. See for example Chamberlain v. Commissioner, 2 T.C.M. 469 (1943) and McDonald v.
Commissioner, 3 T.C.M. 274 (1944). In both of these cases, the Tax Court held that, although
the buy-sell provisions did not establish the gift tax value of the gifted shares, the existence of
the rights of first refusal nevertheless had a depressing effect on the gift tax value of the shares.
II. The Effect of Buy-Sell Agreements on the Estate Tax Marital Deduction for Estate
Planning Purposes.
Another potential trap for the unwary in dealing with Buy-Sell Agreements is the
possible consequences that the existence of a Buy-Sell Agreement may have upon whether a gift
or bequest will qualify for the marital deduction for estate tax purposes. Frequently, under an
estate plan, a substantial portion of a decedent's estate will pass to the surviving spouse either
outright or through a type of trust (such as a qualified terminal interest property trust) which
qualifies for the marital deduction for estate tax purposes.
Under Section 2056, an estate may claim the marital deduction for the value of property
passing to a surviving spouse at the decedent’s death. No marital deduction will be available,
however, where the surviving spouse’s interest may terminate or fail on the happening of certain
events.
Under Sections 2056(b), no marital deduction is allowed if an interest transferred to a
spouse is a "terminable interest." Under Reg. 25.2056(b)-1(b), a terminable interest is an interest
which will terminate or fail on the lapse of time or upon the occurrence or failure to occur of
some contingency. Likewise, under 2056(b)(5), a marital trust will qualify as a qualified
terminable interest property trust only if the trust insures that no person other than the surviving
spouse will ever be entitled to any distributions from the trust.
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Therefore, for example, where stock is transferred or bequeathed to a spouse of the
transferor, or to a trust for the spouse’s benefit, subject to a buy sell agreement, the issue arises
as to whether the purchase options in favor of other third parties could be deemed to cause the
termination of the spouse's interest. If this is the case, then the gift to the spouse will be a
"terminable interest" which will not qualify for the marital deduction.
In TAM 9147065, the decedent bequeathed all of his stock in a closely held corporation
to a QTIP trust for the benefit of the surviving spouse. Under the decedent's will, however, the
decedent's two children had the option to purchase his stock in the closely held corporation at
any time within the next two years at an option price of $1,000 per share. At the time of the
decedent's death, the fair market value of each share of stock in the decedent's estate was
$11,000 per share.
In that case, the estate sought to claim the marital deduction for the value of the stock
passing to the QTIP trust. However, the Internal Revenue Service disallowed the marital
deduction to the extent of the stock transferred to the QTIP trust. In light of the fact that the
option price was so far substantially below current fair market value, the IRS concluded that the
existence of the option constituted a power of appointment in favor of the decedent's children. In
essence, over 90% of the value of the stock placed in the trust would pass to the sons upon their
exercise of the purchase options. Thus, the sons had a power of appointment over the marital
trust property in favor of themselves which caused the trust to be disqualified from the marital
deduction. See also TAM 9139001 (April 30, 1991).
Likewise, in Renaldi v U. S., 97-2 USTC ¶ 60,281 (Fed. Cl. 1997), aff’d, 178 F. 3d 1308
(Fed. Cir. 1998), the court held that a bequest of stock to a QTIP trust did not qualify for the
marital deduction, because the decedent’s son was given the right, under the decedent’s Will, to
purchase stock at less than fair value - even though the stock was actually redeemed at fair
market value before the estate made the QTIP election.
III. Provisions in the Buy-Sell Agreement May Prevent Gifts of Business Interests
From Qualifying for the $13,000 Annual Gift Tax Exclusion.
In Hackl v. Commissioner, 335 F.3d 664 (7
th
Cir. July 7, 2003), aff'g, 118 T.C. 279
(2002), Albert and Christine created Treeco LLC, to own and operate a tree farm. They
anticipated that the farm would produce no current income, but would eventually produce
significant capital gains. The taxpayers formed the LLC, transferred assets to it, and then
assigned LLC membership interests to their children, their grandchildren, and to trusts for their
grandchildren.
The LLC Operating Agreement named Albert as the manager of the LLC for life, and
gave him the right to determine when and if distributions would be made, but any distributions
had to be made to all members of the LLC, in proportion to their membership interests. No
member could withdraw any of his or her capital account or compel the LLC to make any
distributions without the approval of the manager.
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In addition, under the LLC Operating Agreement, Members could not withdraw from the
LLC without the prior consent of the manager. A member could, however, offer to sell his or her
units of LLC interest to the LLC, if the manager chose to buy them. A member could sell or
otherwise transfer his or her interest to an outside third party only with the manager's consent.
Each member could vote to remove the manager and elect a successor, though an 80-percent vote
was required to do so.
The Hackl’s gift tax returns were audited, and the IRS asserted a gift tax deficiency of
$400,000 on the basis that gifts made by Mr. and Mrs. Hackl during the tax years did not qualify
for the $10,000 annual gift tax exclusion.
The Tax Court agreed with the IRS that the taxpayers' gifts of membership interest did
not qualify for the gift tax annual exclusion, because the restrictive provisions of the LLC
agreement did not give the donees a "present interest" with respect to gifted LLC membership
interests. The Court stressed that the present interest rule requires that the donee receive a
"substantial present economic benefit" from the possession, use, or enjoyment of the gift
property or the income generated by the gift property, which benefit the court found lacking in
this case. Citing Fondren v. Commissioner 324 U.S. 18, 20-21 (1945); Ryerson v. United States,
312 U.S. 405, 408 (1941); United States v. Pelzer, 312 U.S. 399, 403-404 (1941). The court
stated that transfers of interests in a family LLC were taxed under the same rules applicable to
transfers of interests in trust, because to do otherwise would be to allow the taxpayers' choice of
the form of transfer to dictate the tax results.
The court also rejected the taxpayers' contentions that the annual exclusion should be
available because the donees' interests were fully vested, and were identical to the interests
retained by the donors. The court stressed that neither of these facts established the existence of a
substantial economic benefit. The court rejected the argument that the future gains from the
property created a present interest, because those gains were postponed and were not, therefore, a
present substantial benefit. The court also denied that there was a present interest in the income
from the LLC, because the LLC held non-income producing assets and anticipated retaining
those assets indefinitely.
The Seventh Circuit affirmed, in a relatively brief opinion. The court noted that the
burden is upon the donor to show that the gift was of a present interest qualifying for the annual
exclusion. The court viewed the essence of the taxpayer's contention as that the annual exclusion
applies if the donor transfers full ownership of an interest, retaining no rights in the transferred
assets. The court stated that the regulations' definition of a present interest as "[a]n unrestricted
right to the immediate use, possession, or enjoyment of property or the income from property
(such as a life estate or term certain)" does not automatically cause an outright transfer to
constitute a present interest gift. Regs. § 25.2503-3.
(7th Cir. 2000), in which the forgiveness of a corporation's debt was deemed to be a future
interest, because shareholders could not individually realize the gift without liquidating the
corporation or declaring a dividend, and no one individual, under the corporation's bylaws, could
compel these events. In other words, the court stated, a "present interest" requires the right to
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substantial present economic benefit, which did not occur in Hackl, because the operating
agreement so restricted the transferred voting shares so as to render them "essentially without
immediate value to die donees."
The operating agreement in Hackl gave the donee members very little control over the
economic activities and benefits of the LLC, but these terms are only slightly more severe than
those of most FLPs and LLC’s.
Note: One approach adopted to create a present interest is to permit the donee members
freely to sell their membership interests. This caries no significant risk that the donees
actually will sell their interests, because virtually no one will buy a minority or nonvoting
interest in an FLP or LLC. In Hackl, however, the members could sell their assignee
interests, but not their membership interests. It is not clear that a right to sell one's
membership interest would provoke a different response than the rights held in Hackl.
Another approach to assuring the availability of the gift tax annual
exclusion for a gift of an FLP or LLC interest is to give the donees a Crummey
withdrawal power with respect to gifts of their interests. Such a right would
enable the donee to withdraw their share of the partnership capital for a limited
period after each gift. Such a right would, however, reduce or eliminate any
discount for lack of marketability or control with respect to that portion of each
gift that qualified for the annual exclusion, but that is a modest penalty to pay for
the entire elimination of the gift tax on the first $11,000 of gifts to each donee
each year.
The best approach may be to give each donee the temporary right to "put"
his or her interest to the partnership for an amount equal to its fair market value,
taking into account all applicable discounts. This is functionally equivalent to a
Crummey power, and so should obtain the gift tax annual exclusion. It also should
preserve the appropriate discounts. The lapse of the put right could be an event
described in Section 2704(a), but this would cause a taxable transfer by the donee
of the difference between the value of the partnership interest with the put right
and the value of the interest without it. Code § 2704(a)(2). This figure should be
zero.
CONCLUSION
By implementing a buy-sell agreement, business owners can gain some sense of security
and predictability in an otherwise insecure and unpredictable relationship. A buy-sell agreement
can address a number of issues in the business relationship, including potential voluntary and
involuntary transfers, death, deadlock and disability. Proper structuring of the agreement,
including establishing a method to determine the purchase price, who will be the purchaser and
how to fund the purchase of stock, is imperative to meet the intentions of the parties.
Doc. 896777
