All posts in Buy-Sell Agreements

08 Apr

How to Dispose of Your Interest in a Closely Held Business: Alternatives to Buy-Sell Agreements

In Buy-Sell Agreements,Corporations by admin / April 8, 2013 / 0 Comments

Estate Planner Mar-Apr 1999

Selling stock in your closely held business may be difficult due to a limited market for it. Although buy-sell agreements provide the way your interest will be bought and sold, alternative methods allow you to both address these concerns and receive financial benefits from the company without selling your stock.

A Few Alternatives

With proper planning, your company can provide you with significant financial benefits. Here are some alternatives:

Deferred compensation. Under a deferred compensation agreement, your company can pay you after your retirement or death, either for services rendered or as payment for recognition of past work. You and your company can establish a substantial severance package before you leave its employ. The company can deduct the severance payments, if reasonable, as a business expense.

Covenant not to compete. Payments your company makes pursuant to a covenant not to compete can provide additional funds to you. The company can also deduct these payments as business expenses. But the covenant must be reasonable in light of all surrounding circumstances. If the IRS finds the covenant to be suspect, it can treat the payments as a dividend to you and the company will not get a deduction.
Benefit plans. Certain retirement plans, such as defined benefit plans and target benefit plans, can quickly fund large retirement accounts for older employees. Their structure allows larger payments to older employees because the payments to younger employees are projected to continue for a longer period of time. An employee stock ownership plan (ESOP) acquiring the company’s stock can work similarly. This option may be especially attractive because the gain on the sale of your stock to the ESOP can be deferred and receive a step-up in basis at death.

Stock redemption. If your company cannot purchase your interest for cash on your death or retirement, it can redeem your stock in exchange for company assets through a taxable transaction. Then you can either sell the assets or lease them back to the company. Or, the company can create a market for your stock by paying reasonable bonuses to your children or other younger employees that they can use to purchase your stock.

Sale of the company. If the company doesn’t have enough cash to buy you out, the other owners can sell it while remaining involved through employment and consulting agreements. Or, you could wind down the business while your children begin a new, similar business. You receive the accounts receivable of your closed company. In effect, its goodwill will inure to the benefit of your children’s company without there having been an actual transfer.

Charitable remainder trust. If you are charitably inclined, you can use your stock in the company to fund a charitable remainder trust that provides you income and allows you to receive an income tax deduction for the remainder passing to charity when the trust terminates. Your children can have a right of first refusal to repurchase the stock, which may be useful if the charity has no interest in owning the stock. If income is not your goal, then you can make an outright gift of stock to the charity and avoid any gain on the stock gifted while receiving an income tax deduction.

Gifting to children. If you have sufficient other resources, your stock may be an appropriate asset to establish a gifting program to your children.
Spin-offs. If you and other owners are concerned about conflicts, then you may want to consider dividing the company through either a tax free spin-off, split-off or split-up that allows each owner to receive a separate part of the business.



Consider Your Goals

Careful consideration of your goals can help determine how you should dispose of your closely held business interest. Remember, though, that any arrangement must reflect a bargained-for agreement between you and the other parties — a court will look for this if a dispute arises later. If you are interested in learning more about how alternatives to a buy-sell agreement may work for you, please call us. We would be happy to discuss your situation and help you determine how to best dispose of your interest in a closely held business.

08 Apr

Creative Financing – Designing and Funding A Buy-Sell Agreement for your Business

In Buy-Sell Agreements by admin / April 8, 2013 / 0 Comments

Estate Planner Jan-Feb 2006

If you own a business, it’s probably your most valuable asset. So it’s important to take steps to preserve that value for your family after your death or in case you become disabled or leave the business for some other reason. One of the most powerful tools available to help you achieve that goal is a buy-sell agreement.

A buy-sell agreement creates a market for your interest in the business, providing liquidity to pay estate taxes and other expenses, and smoothing the transition from one generation to the next. Because the agreement provides for the company or the other owners to buy you out, it’s critical to make arrangements to fund the purchase.

Buy-sell benefits

A buy-sell agreement is a contract among the owners of a business that provides for the company or the remaining owners to buy back a deceased, disabled or departing owner’s interest under specified circumstances for a specified price. Typical “trigger events” include:

· Death,
· Disability,
· Divorce,
· Retirement or termination of employment,
· Bankruptcy, and
· Loss of a professional license.

By establishing buyout terms, a buy-sell agreement creates a market for otherwise unmarketable shares, providing a source of liquid funds the owner’s heirs can use to pay estate taxes and other expenses without being forced to sell the business.

A buy-sell agreement also can help keep ownership of the business within a family or another select group by preventing: 1) departing owners from selling their interests to outsiders, and 2) an owner’s spouse from acquiring an interest in a divorce proceeding.

Other potential benefits of a buy-sell agreement include minimizing disputes among owners over price and other buyout terms, and establishing the value of the business for gift and estate tax purposes (if certain requirements are met).

Types of agreements

There are two basic types of buy-sell agreements: redemption and cross-purchase. Under a redemption agreement, the company buys back a departing owner’s interest, and under a cross-purchase agreement, the remaining owners purchase the interest. Each has advantages and disadvantages:

Redemption agreements. An important distinction of a redemption agreement is that the company is responsible for funding the buyout, not the other owners. Redemption agreements have some big drawbacks, especially if the company is a C corporation. For one thing, if a redemption agreement is funded by insurance on the owners’ lives, insurance proceeds received by the company may trigger corporate alternative minimum tax (AMT). The company can avoid AMT by funding the agreement with corporate savings rather than life insurance, but this approach can create accumulated earnings tax (AET) issues.

Another disadvantage of a redemption agreement is that the company’s purchase of an owner’s interest enhances the value of the remaining owners’ shares – because each owner now owns a greater percentage of the company – without a corresponding step-up in tax basis. A lower tax basis potentially increases the tax hit for owners who later sell their interests.

Cross-purchase agreements. These agreements can provide several advantages but can be unwieldy and expensive – especially for larger companies – because each owner must maintain insurance policies on the lives of all of the other owners. On the plus side, however, in addition to avoiding AMT and AET problems, cross-purchase arrangements provide the remaining owners with additional tax basis in any acquired interests, reducing their capital gains – and, therefore, their taxes – if they sell their shares.

Considerations for pass-through entities

The disadvantages of redemption agreements are generally less of a concern for pass-through entities – such as S corporations, partnerships and limited liability companies – because they’re not subject to AMT or AET.

Also, there is less of a basis issue on pass-through entities. Like a C corporation, a pass-through entity’s buyout of a deceased or retiring owner doesn’t produce a basis increase for the surviving owners. But if the buy-sell agreement is funded by life insurance, the basis of all owners is increased by the pass-through entity’s receipt of the insurance proceeds.

For example, Tom, Dick and Harriet each own one-third of the stock of TDH Advisors, an S corporation valued at $3.6 million. Under a cross-purchase agreement, if one of the shareholders dies, the other two are obligated to buy back the shares for $1.2 million. To fund the agreement, Tom, Dick and Harriet each buy $600,000 life insurance policies on the lives of the other two shareholders. When Tom dies, Dick and Harriet each collect $600,000 in life insurance proceeds tax-free and use those funds to buy half of Tom’s shares. Dick’s and Harriet’s interests in TDH Advisors increase in value by $600,000 each, but they also enjoy a basis increase of $600,000.

Suppose, instead, that TDH Advisors and its shareholders have a redemption agreement that requires the company to buy back Tom’s shares for $1.2 million, funded by a $1.2 million life insurance policy. Even though the company, rather than the shareholders, buys Tom’s shares, Dick and Harriet each become 50% owners, so the value of their shares increases by $600,000 each. The basis of each shareholder (including Tom) is increased pro rata by the $1.2 million in life insurance proceeds collected by the S corporation. Thus, Dick’s and Harriet’s bases both increase by $400,000. Tom’s basis also increases by $400,000, but that increase is wasted because Tom’s estate receives a stepped-up basis equal to the fair market value of his shares.

Setting the price

Your buy-sell agreement’s terms for valuing the company’s shares and setting the purchase price are critical. Generally, the most effective method is to conduct regular, independent appraisals of the business, but a well-designed valuation formula can be an effective low-cost alternative. If you use the formula approach, however, there’s a risk the IRS will find that the business is undervalued, creating unexpected estate tax liabilities, interest and penalties.

Funding options

There are three basic methods of funding a buy-sell agreement:

1. Savings plan. The company or its owners simply save enough money to cover their obligations under the agreement. The problem with this approach is that funds may not be available if an owner dies or leaves the business sooner than expected or if savings are needed for unforeseen expenses. It also can cause AET problems for a C corporation.

2. Bank loans. When an owner dies or leaves the business, the company or the remaining owners borrow the money needed to fund the buyout.

But this approach can fall short if the company or its owners run into financial difficulty and have trouble obtaining a loan.

3. Life insurance. In most cases, life insurance is the most cost-effective method of funding a death buyout under a buy-sell agreement. It ensures that the funds will be available when needed. In addition, the insurance proceeds are generally tax-free (but watch out for AMT issues raised by C corporation redemption agreements).

Complex planning issues

Developing a buy-sell agreement that’s right for your business requires consideration of a number of complex tax and business planning issues. Thus, it’s wise to consult legal, tax and financial advisors to design an agreement and funding mechanism that meets your needs.

Sidebar: FTD delivers cost savings

For many businesses, first-to-die (FTD) life insurance offers a lower-cost alternative to
traditional insurance for funding a buy-sell agreement. In a typical buy-sell arrangement, individual life insurance policies are purchased for each owner. Alternatively, an FTD insures two or more lives simultaneously and pays a death benefit on the death of the first insured to die.

The primary advantage of FTD insurance is lower premiums: An FTD policy covering two people typically costs 25% to 30% less than two individual policies. But even though FTD insurance is an effective alternative for a redemption agreement, it can present some tricky tax and planning issues for cross-purchase agreements.

Joint ownership of an FTD policy used to fund a cross-purchase agreement may cause the insurance proceeds to be included in the deceased owner’s taxable estate and may also have negative income tax consequences. Many experts believe this result can be avoided if the buy-sell agreement requires the proceeds to be used to purchase the deceased owner’s interest or if the FTD policy is owned by a properly designed trust. The problem is that there’s little guidance on this issue and it’s difficult to predict how the IRS or the courts will treat such an arrangement.

08 Apr

Funding a Buy-Sell Agreement with Life Insurance? A Partnership May Make the Best Policy Owner

In Buy-Sell Agreements by admin / April 8, 2013 / 0 Comments

Estate Planner May-June 1997
A buy/sell agreement provides that a deceased shareholder’s shares in a closely held business either will be redeemed by the corporation or purchased by the remaining shareholders. Life insurance is often used to provide the necessary cash to buy or redeem the shares. But who should own the insurance? A partnership is often a good choice for several reasons.

Avoid the AMT

If a C corporation owns insurance on the lives of the shareholders to fund a redemption agreement, the insurance proceeds paid to the corporation may be subject to the alternative minimum tax (AMT). As a result, the net proceeds may be less than what is needed to fund the stock redemption. A partnership can solve this problem. In various private letter rulings, the Internal Revenue Service (IRS) has sanctioned the transfer of life insurance currently owned by the corporation to an affiliated partnership, such as a partnership of shareholders that owns the real estate where the business operates. The partnership can be the designated beneficiary of the policies on the lives of the other partners. Because the proceeds are not payable to the corporation, the AMT is avoided. The transfer out of the corporation may be a dividend.

Avoid the Transfer-for-Value Rule

Although life insurance proceeds generally are excluded from income, if a life insurance policy is transferred for valuable consideration, the proceeds are subject to income tax. Partnerships can avoid this problem, however. If the transfer is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer, the proceeds payable are not subject to income taxation.

Avoid Incidence of Ownership

Insurance proceeds generally will be included in the insured’s estate if he or she possesses any right to receive, alter, revoke or affect the economic benefits of the insurance policy. Such rights are referred to as incidence of ownership. Partnerships, however, may avoid this problem. The IRS has ruled that if a general partnership is the owner and beneficiary of life insurance policies on the life of each general partner, the partner does not have incidence of ownership as long as the proceeds are used for the benefit of the partnership. The value of the decedent’s partnership interest may include his or her proportionate share of the death proceeds, but the deceased partner’s estate will not include the balance of the death benefit.

Avoid Multiple Policies

Cross-purchase plans are common in buy/sell agreements. Each shareholder purchases a life insurance policy on each other owner’s life. When an owner dies, each shareholder uses the proceeds from his or her policy on that owner’s life to purchase that owner’s shares. However, this system can become quite complicated when there are more than a few shareholders because so many policies are required. For example, a business with five shareholders would require four policies on each partner’s life — one owned by each other partner — for a total of 20 policies. With a partnership, the partnership can own the policies so only one policy is needed on each life.

How Is Insurance Held?

The life insurance partnership can be a valuable business planning tool. For example, the proceeds can be used to purchase interests in several entities owned by the partners, eliminating the need to have separate agreements and separate policies for each entity. Shareholders often don’t realize until it’s too late that the life insurance they purchased to fund a buy/sell agreement is not being held in the most tax-efficient way possible.

08 Apr

Buy-Sell Agreements: Stability in a Time of Uncertainty

In Business Issues,Buy-Sell Agreements by admin / April 8, 2013 / 0 Comments

Estate Planner May-Jun 2000

Retirement doesn’t have to be right around the corner before you plan for it. Have you considered how your stake in your company will be handled when you retire? What if you were to die before retirement? Will your family be forced to negotiate the sale of your interest? A buy-sell agreement can help circumvent many business transition problems and stabilize what could otherwise be difficult periods of uncertainty.

What Are Triggering Events?

A buy-sell agreement is a popular tool to transfer a stake in a business upon the occurrence of a predefined event called a triggering event. Some triggering events include:

  • Death,
  • Disability,
  • Retirement,
  • Bankruptcy,
  • Divorce,
  • Voluntary or involuntary termination of employment, and
  • An involuntary sale of stock.

After the triggering event occurs, the buy-sell agreement dictates the sale according to the agreement’s terms. The agreement specifies, among other things, who will buy the stock and at what price. (Although we are discussing the sale of stock, a buy-sell arrangement applies equally to interests in partnerships and limited liability companies.)

Both your business and your family benefit from a properly designed buy-sell agreement. For example, at your death, a buy-sell agreement will reduce much of your family’s economic uncertainty. Without the agreement, difficult negotiations could ensue between your family members (who may have an unrealistic view of the company’s value) and surviving shareholders.

Buy-sell agreements also help preserve the surviving shareholders’ control of the company by restricting stock transferability and controlling who may become shareholders. An orderly transition can help prevent the business from being dissolved in a distress sale caused by internal dissent.

Stock in a closely held business is generally an illiquid asset, but the buy-sell agreement can provide your estate with sufficient cash to pay:

  • Death taxes,
  • Debts and administration costs, and
  • Support and living allowances for family members.

Furthermore, during your lifetime, you hold the best bargaining position to maximize the purchase price. Family members generally do not have sufficient knowledge of the business or leverage to exact the best possible offer from the corporation or other shareholders. And obtaining a predetermined value for your stock can offer certain federal estate tax benefits because in some cases your stock may be given a lower valuation for estate tax purposes.

Types of Buy-Sell Agreements

The buy-sell agreement is generally structured as either a stock redemption or a cross purchase. Here’s a closer look at each:

Stock redemption. Stock redemption allows the business to use its funds to buy your stock. Life insurance commonly funds the company’s purchase of the shares when you die. The stock redemption structure assures that the premiums are paid on time, giving you peace of mind. If insurance funds your stock purchase, the stock redemption approach could also alleviate some administrative burdens not covered with a cross-purchase structure. Though the stock redemption structure is easier to administer, the cross-purchase structure can lower the overall tax burden.

Cross purchase. Surviving shareholders buy back your stock at your death under a cross-purchase buy-sell agreement. The arrangement is almost as if your shares are pieces of a pie. When one shareholder experiences a triggering event, the others must buy his or her shares. While it seems simple, it’s not. The cross-purchase agreement places unequal financial burdens on newer or younger shareholders. For example, a 10% shareholder may be required to purchase a 90% shareholder’s interest.

You can create a hybrid agreement if you are not sure which structure best suits your needs. The hybrid agreement gives the corporation the option to buy the stock. If the corporation’s option expires, then the shareholders are either given the option to buy the stock or are required to buy it. This arrangement allows the parties to determine the best structure at the most opportune time.

Which Buy-Sell Agreement Is Best for You?

If you think a buy-sell agreement may be useful to you, please contact us. Our professionals would be happy to discuss your business situation to arrive at the solution that fits your needs.