Persons holding equity interests in a business can use a buy-sell agreement to ensure the continuity of the business and to solidify their expectations regarding the taxes, rights, and obligations of each party. The buy-sell agreement can dictate the method by which a person’s equity interest will be purchased. Buy-sell agreements can be used by nearly any type of entity, regardless of whether the entity is a corporation, LLC, or partnership.
Beside the practical business and tax benefits, a buy-sell agreement also allows the parties to plan in advance of the moment when the ownership change will eventually occur, and, thus, allows the parties to avoid much of the tension and emotion that can result from delaying such discussions. In addition, the buy-sell agreement also forces the parties to consider financial issues that often can only be solved if addressed well in advance, such as whether the company should purchase life insurance to fund the transfer.
The buy-sell agreement is a legal contract that dictates how, when, and for how much a company or remaining owners will be required to pay to acquire the interests of a departing owner. The buy-sell agreement will typically provide for various triggering events that will either gives one party the obligation or the option to buyout the interests of another. Typical events include: death, disability, divorce, bankruptcy, retirement, or otherwise changing their role in the company. Many owners will be concerned about the ownership rights and control of the company. Other owners will want to ensure payment for the departing owner, and still other owners will want the buy-sell agreement to minimize the tax burdens of the company and the departing and remaining owners. Thankfully, buy-sell agreements are not one-size-fits-all, and an attorney will be able to address many, if not all, of these concerns.
While an attorney is virtually unlimited in choices that can be made in drafting and implementing the buy-sell agreement, there are primarily two types of agreements: the redemption agreement and the cross-purchase agreement. Of course, even this choice can provide alternatives, such as a mixed agreement that allows members or shareholders the option to purchase the interests of the departing owner before requiring the company itself to purchase the owner’s interests.
A redemption agreement will cause the entity to purchase the interest of the departing owner. Many favor using the redemption agreement for buy-sells because of its simplicity, particularly when there are numerous owners. If life insurance is needed to fund the purchase, a redemption agreement will typically require the purchase of only one policy. And, since the company purchases the interests of the departing owner, no particular owner will have their interests increased in relation to the other remaining owners. Of course, if one remaining owner already controls a substantial position of the company, then this could push that owner over a threshold such as the 50% ownership mark or other critical amount designated in the company’s bylaws or operating agreement.
While a redemption agreement has its advantages, it does have its limitations as well. The redemption agreement will cause the entity to purchase the interests of the departing owner. Thus, while the value of the remaining owners’ interests will increase in value, the shareholders of a c-corporation will see no increase in their tax basis. So, when those shareholders sell their interests in the c-corporation, they will pay gain on the increased value of their shares. In contrast, the tax basis of remaining s-corporation shareholders and partners in an LLC or partnership can be increased, regardless of whether the chosen method is a cross-purchase or a redemption.
In addition, if the entity using the redemption agreement is a c-corporation, then attribution rules may prevent the redemption from being considered a “complete redemption”, and, thus, may be considered taxable as a dividend to the departing owner. This is particularly relevant when the remaining owners are closely related to the departing shareholder. Further, a redemption of c-corporation shares may have alternative minimal tax consequences if the corporation receives insurance proceeds to fund the transfer.
Regardless of the entity’s tax status, insurance proceeds going to an entity to fund a buy-sell redemption agreement may be subject to claims of the entity’s creditors. A redemption agreement, on the other hand, requires only one life insurance policy per owner and is typically the simplest transfer to structure and implement.
A buy-sell agreement can also be structured as a cross-purchase agreement. The cross-purchase agreement can be more complicated. The cross-purchase agreement requires that some or all of the remaining owners be required to purchase the interests of the departing owner. If life insurance will be used to finance the purchase, then each owner may need a policy on each of the other owners. The individual owners would receive the insurance proceeds and will then use the proceeds to purchase the interests of the departing owner. Since the individual owners, rather than the corporation, purchases the shares, this removes the tax basis issues that exist for c-corporations under a redemption agreement. Further, for c-corporations, since the individuals receive the life insurance proceeds, the corporation should not encounter any corporate alternative minimum tax issues.
Mixed agreements are those providing options to buy the interests by either the entity or the remaining interest holders followed by either the remaining interest holders or the entity having the right or obligation to purchase. Either of these parties may purchase life insurance to fund the transfer. Of course, the agreement can allow new parties to purchase the interests, such as a child of the departing owner.
Funding the Transfer
While much has been discussed in this article regarding the use of life insurance policies to fund buy-sell agreements, life insurance may not be helpful if it is likely an owner will desire to sell their interests to fund their retirement. In such a case, the entity has several options. The entity or remaining interests’ holders could, of course, stockpile cash over time through investments. In addition, the parties may use insurance policies that will accumulate a cash value. Still another possibility is the use of an installment agreement whereby the shares are purchased over time from either the entity’s future earnings or through dividends to the remaining interest holders. Again, if the departing interest holder continues to have interests in the entity, whether directly or through IRS attribution rules, the departing owner of a c-corporation may be considered to have received dividends rather than capital gains. Depending upon the tax rates then in effect, the IRS the reclassifying the payments as a dividend may have a negative effect.
Estate Tax Uses
The buy-sell agreement usually provides some method of valuation of the owners’ interests, whether by calculation or a fixed amount. The value, as calculated under a buy-sell agreement, can often be used for estate tax valuations. The IRS; however, may challenge values to be used for inter-family buy-sell agreements, particularly when the amount is less than reasonable and cannot be justified. In choosing whether to use a cross-purchase agreement or redemption agreement, a person concerned about estate taxes may favor a cross-purchase agreement. If an owner dies controlling the majority of a business that used a life insurance policy to fund a redemption buy-sell agreement, then both the business and the life insurance policy could be considered owned by the person’s estate. Since entity-owned policies are typically used for redemption agreements, this situation may favor the use of cross-purchase agreements for owners with estate tax issues.
Buy-sell agreements provide many benefits to business owners, but careful consideration should be used when determining how the buy-sell agreement should be structured. Since buy-sell agreements are naturally forward-looking, reasonable projections must be made regarding financial requirements, both for funding and valuation purposes. Moreover, when the ultimate success of the buy-sell agreement requires that the business survive, consideration should be given to ensuring the future owners are given the necessary means and training to make this transition successful. Your attorney, in drafting your buy-sell agreement, should be willing to meet with the owners, financial planners, accountants and any other individual needed to ensure the buy-sell agreement meets the current and long-term goals of the owners and the company.
For additional information or to obtain a buy-sell agreement for your company, please contact Jeff Rogyom at (410) 929-4578. Please review the Disclaimer page regarding use of this website and its information.