Buy-Sell Agreements / Shareholders Agreements - Death Buy-Outs - PART II

This is our second post on Buy-Sell Agreements. Here we will be focusing on what items go into the specific provision, and considerations you need to review.

When setting up a Buy-Sell, you need to make very serious choices, including:

• The identity of the purchaser;
• The pricing mechanism;
• The triggering events, including death, disability, retirement and dispute;
• The degree to which the buy-out is optional or mandatory; and
  
• Interim restrictions.

We will look at all of these in more detail.

Identity of Purchaser

Typically, you want the purchaser to be either the corporation itself or the other existing shareholders. Corporate redemption allows use of corporate earning power to make the purchase with a single tax on the earnings used for the purpose. This is important for a C corporation, and less so for an S corporation, unless it has a C corporation history.

A cross purchase requires shareholders to use their own resources to purchase, but gives them some shares with a new purchase price (usually a stepped up basis). This can be important is they make subsequent dispositions of less than all of the shares by gift or sale.

Combinations are also possible, such as giving the corporation a first option to purchase, with the shareholders having either a second option or a duty to buy if, or to the extent, the corporation does not.

Pricing Mechanism

There are various pricing mechanisms you can use when setting up these provisions:

• Fixed price - is the simplest, but must be amended from time to time, which often it is not - people are usually too busy running the company. An alternative can be devised if the fixed price is not revised within a specified period, for example, three or five years.
• Formula price - usually is based on book value or earnings. Book value should be adjusted for collection of proceeds of life insurance, good will, effects of accelerated depreciation, right offs of R&E, and use of LIFO inventory.
• Appraisal - is more accurate as it establishes the price at the time of the buy-sell transaction, but it is more cumbersome and more expensive.
• One to price and one to choose - one shareholder fixes the price per share, and the other shareholder can either buy or sell at the stated price. Similar to the "Texas" or "shotgun" option.
• Combinations of the foregoing can also be used.
  

Triggering Events

It is important to specifically list which events will trigger the purchase/sale.

• Death - shares will have a basis equal to their estate tax value under Code §1014. Note that in family corporations, purchase during life may have advantages in meeting redemption standards of IRC §302(b)(3) and (c) because of different applications of the attribution rules under IRC §318. At death, purchasers may qualify all or part of the redemption as a sale or exchange under IRC §303. Sale or exchange treatment is less important for lifetime transfers at current rates without significant capital gains rate preferences. Deferring redemption until death may permit the redeeming shareholder's estate to elect installment payment of estate tax under IRC §6166 when the purchase price is paid in installments.

• Disability - this triggers the right upon disability of a shareholder, usually permanent disability, because the shareholder can no longer actively partake in the company's affairs.

• Retirement - When a shareholder will no longer be working for the company, you want to make sure that he/she will have to sell the shares back to the company or to the other shareholders who are actively working for the company.

• Dispute - When there is a deadlock about certain decisions, it is sometimes advantageous to have the shareholders exercise their rights under one of these provisions, instead of the company coming to a halt.

Optional or Mandatory

A mandatory arrangement provides greater assurance that the stated price will fix estate tax values. Having a mandatory arrangement also allows more certainty in business planning, because you know that if a certain event happens, then a shareholder will have to buy/sell shares. Making it optional takes away some of the certainty.

Transfer Restrictions.

There are various prohibitions on transfer that have to be taken into account.

• S corporation protection.
• Professional corporation protection.
• Fixed price purchase option for attempted transfers.
• Prohibition except with consent of corporation or remaining shareholders.
• Right of first refusal.
• Right of first offering.
• To be effective for estate tax purposes, the agreement must provide either a formula equally binding during life and at death, or a restricted price for lifetime transfers that does not exceed the price stipulated to be paid at death.
• Transfer restrictions related to employment imposed at the time of initial acquisition of corporation's shares raises IRC §83 issues. This is true even if the shareholder/employees subject to the restrictions pay the same per share price as others who are not. The tax consequences of the restrictions vary significantly, depending on whether the restrictions will last throughout the period of ownership, or whether they are scheduled to expire. Any compensation upon receipt of shares subject to non-lapse restrictions is measured by the value of the shares as reduced by the restriction. Compensation upon receipt of shares subject to lapse restrictions is measured by the full value of the shares, without taking into account any depressing effect of the restrictions.

Buy-Sell Agreements / Shareholders Agreements - Death Buy-Outs - PART I

We will be publishing a series on how small companies with more than one owner can structure their affairs if one of the owners should die, or some other contingency occur. Typically this is done in what is called a "Buy-Sell Agreement", which can also be called a Shareholders Agreement, for a closely held corporation. (you can set up a similar structure for LLC's and partnerships, the provisions will be contained in the Operating Agreement or Partnership Agreement, respectively). So while we will discuss the topic as it applies to corporations, just remember that it can apply to almost any business entity with more than one owner.

A Buy-Sell Agreement is an arrangement among shareholders of a corporation (or occasionally between a sole shareholder and one or more key employees) that provides for the purchase of the shares of one or more shareholders in specified circumstances. They must be reviewed periodically, because the business's financial situation may change significantly, particularly as it matures from its initial start up.

Why would you want a provision requiring purchase of shares in certain circumstances?

• Protects active shareholders by ensuring, when this is the deal, that all corporate shares are owned either by active shareholders or by persons who are willing to terminate when active involvement of a related person ends.

• Protects minority shareholders by preventing their being locked into an illiquid and non-income producing investment.

• In family corporations, it provides a formula for the valuation of the shares that may be effective for estate tax purposes, even though the purchaser is a family member. The Internal Revenue Code of 1986, section 2703 provides stringent requirements that the buy-sell agreement must meet, if it is not to be taken into account in valuing property for transfer taxation purposes. It may be used to provide senior securities, debt or preferred stock for the inactive family members and common stock for the active ones, even when the decedent was the sole shareholder, however, the stringent requirements of IRC §2701 must be met.

In later posts we will discover how you can use one of these provisions to your benefit and the benefit of your business.