Buy-Sell Review. Report Summary. Prepared for Hawkeye Medical Group, Inc. Sample City, IL

Transcription

1 Buy-Sell Review Report Summary Prepared for Hawkeye Medical Group, Inc. Sample City, IL Thank you for requesting a Principal Buy-Sell Review. We have received the following documents: Shareholder Buy-Sell Agreement ( Agreement ), dated September 16, 2004 Business Planning Fact Finder ( Fact Finder ) Please note this Buy-Sell Review (Review) is based on our review of these documents and is intended to be used as a basis for discussions with your tax and legal advisors. To the extent these documents are invalid or other pertinent documents exist of which we are not aware, the observations, recommendations and analysis contained in this Review may be inaccurate. The Principal Financial Group (The Principal ) does not provide tax or legal advice. The Buy-Sell Review does not provide you with a legal opinion as to the legal or tax implications of your agreement or the appropriateness of any funding strategies. The Principal cannot provide you with any legal document or revise existing legal documents. Any informal valuation provided will not be a substitute for a formal valuation nor does it establish a value for tax purposes. The Review is intended to help identify your objectives for the buy-sell agreement and any issues that must be addressed to help ensure your objectives are being met. from The Principal Page 1 of 9

2 Background Information Hawkeye Medical Group, Inc. ( Company ) is an Illinois corporation which has elected to be taxed as an S corporation. Shareholders ( business owners ) who are parties to the Agreement include Joe Doaks, George Costanzo, Kosmo Kramer, Elaine Benes, and the Company. 1. An S corporation is generally a pass-through entity for income tax purposes. 2. If there has been a change in the Company s business owners, then it may be advisable to amend the Agreement to either add or delete business owners as appropriate. General Structure of Agreement The Agreement is drafted as a wait-and-see buy-sell arrangement upon the death of a business owner. Under this type of buy-sell arrangement, the purchaser (among the business owners and Company) of the deceased business owner s interest is not determined until the death of a business owner. Under the current Agreement, a purchase following the death of an owner is framed as a purchase option, unless the Company owns a life insurance policy on the deceased owner. If existing life insurance is in force on the deceased business owner, then the Company must purchase the deceased owner s business interest. 1. Discuss with local counsel whether the Agreement should be amended to include to mandatory purchase and sale rights for the death of an owner, even if there is no life insurance in place. 2. An entity purchase buy-sell arrangement provides the simplicity of only one life insurance and/or disability buy-out policy on the life of each business owner. 3. Under an entity purchase arrangement, life insurance policies are generally owned by the business entity and would be subject to the creditors of the business. However, the policies would not be subject to the personal creditors of the business owners. 4. S corporations with three or more owners who currently have a cross purchase buy-sell plan design oftentimes have found it advantageous to convert to an entity purchase buy-sell plan design using the short-year election process of IRC Section 1377(a)(2). In brief, if the S corporation can qualify, this technique can provide a full increase in ownership cost basis to surviving owners and only requires one policy per owner (owned by the Company). Qualification generally requires use of the cash basis from The Principal Page 2 of 9

3 accounting method. Consider amending the Agreement to provide for an IRC Section 1377(a)(2) election. 5. Premiums paid by an S corporation or an entity taxed as a partnership may be considered a non-deductible item at the Company tax reporting level as an expense not properly chargeable to a capital account. Nondeductible expenses generally reduce the owners cost basis in their Company ownership interest. Annual increases in policy cash value, if present, may, in effect, be netted against decreases in cost basis. 6. For pass-through taxation entities, life insurance death proceeds, as taxexempt income received by the business entity, may provide the surviving owners with some cost basis increase for income tax purposes. 7. A major advantage of a wait-and-see buy-sell arrangement over a cross purchase or entity purchase arrangement is greater flexibility. A major disadvantage of this plan design is less certainty, particularly in regard to ownership of buy-sell funding assets. 8. Your tax and legal advisors may provide you with a full list of advantages and disadvantages of the different types of buy-sell arrangements. Agreement Provisions Limiting the Transfer of Ownership No business owner shall sell, assign, transfer, pledge, dispose of or otherwise encumber any of his or her interest in the Company, except as provided in the Agreement. The Agreement permits transfers to a qualified person. A qualified person is defined as a current shareholder at the time of execution of the Agreement. The Majority Shareholders (Doaks and Benes) are exempt from all restrictions and terms of the Agreement for the purpose of any transfer of their shares from one to the other, or from the estate of one to the other. 1. This provision is very common and useful in a well-drafted buy-sell agreement. 2. The Agreement permits certain transfers as noted. 3. It may be helpful to more fully clarify permissible transfers among qualified persons and Majority Shareholders. Right of First Refusal Agreement Provisions If there a bona fide offer to purchase and the business owner desires to accept the offer, then there is a right of first refusal for the Company (first option), with the remaining business owners being provided an option second. from The Principal Page 3 of 9

4 The option price to the Company and business owners is the offer price (rather than the price under the Agreement). The terms of purchase shall be as provided in the Agreement. If the majority business owner is the seller, then the other business owners are granted tag-along sale rights at the same price as the majority business owner. If neither the Company, nor the other business owners elect to purchase, then the selling business owner is free to complete the sale. 1. A right of first refusal purchase price is generally based on (a) the Agreement price; (b) the third party offer price; (c) or the lesser of the Agreement price or the third party offer price. 2. Tag-along rights granted to minority business owners can be helpful to all parties. Mandatory Purchase and Sale Agreement Provisions Death of a business owner is only a mandatory buy-sell triggering event if the Company has obtained and continues to maintain life insurance in force on the deceased owner. In this circumstance, the Company is required to purchase and the estate of the deceased business owner is required to sell. I Disability (undefined in the Agreement) of a business owner is a mandatory buy-sell triggering event requiring the disabled business owner to sell, and the Company to purchase, the disabled business owner s interest. A process to determine disability is not provided in the Agreement. Retirement of a business owner after reaching age 65 is a mandatory buy-sell triggering event requiring the business owner to sell with the Company obligated to purchase the retiring owner s interest. Mandatory purchase obligations also exist for the Company for (1) an involuntary termination without Good Cause (as defined); (2) unable to perform due to illness or injury for six months (not necessarily a disability); and, (3) voluntary termination with Good Reason (as defined). 1. Including death (potentially), permanent disability, and retirement as mandatory buy-sell provisions for buyer and seller are common in buysell agreements. 2. It may be quite helpful to clarify the definition of disability and the process for reaching a determination of disability. 3. Life insurance and disability buy-out funding is discussed below. from The Principal Page 4 of 9

5 Agreement Provisions related to Purchase Options If a business owner dies, and the Company does not own any life insurance on the deceased owner, then the deceased owner s interest is subject to purchase options held first by the Company, and secondarily by the surviving owners. If a business owner is (1) terminated for Good Cause (as defined in the Agreement) or (2) voluntarily terminates his employment without Good Reason (as defined in the Agreement), then the Company, and the remaining business owners shall have the successive right to purchase, with the Company holding the first option. In the event of an involuntary sale or transfer by default, forfeiture, court order, operation of law, or otherwise, such as divorce, bankruptcy, and any settlement arising out of such events, the Company and the remaining business owners shall have the successive right to purchase the affected shares, with the Company holding the first option. Comment: 1. The inclusion of these broadly worded optional triggers appears to cover most of the typical fact patterns that many business owners include as potential triggering events. Agreement Provisions related to Purchase Price The purchase price for death, disability, retirement and involuntary transfers is the amount agreed to between the parties. If the parties cannot agree, then the Agreement indicates that an independent appraisal process is to be used for determining Company value. If the triggering event is voluntary termination without Good Reason, or involuntary termination for Good Cause, then the purchase price as determined above, is adjusted based on time served with the Company. In addition, if the departing owner under this circumstance enters into competition with the Company (as defined in the Agreement), then the purchase as determined above is reduced by 50%. 1. Since the Agreement utilizes an appraisal process to determine Company value, the business owners may want to consider if the Agreement should direct the appraiser to include or not include control premiums or minority discounts. The Agreement may also be used to instruct the appraiser regarding the valuation treatment accorded to life insurance death proceeds. 2. Key employee life and disability coverage may be helpful to the business owners in protecting the value of the business from the unexpected loss of a key employee s services. Typically, the business is the owner, premium payer, and beneficiary of key employee policies. Policy from The Principal Page 5 of 9

6 proceeds may be income tax free, while premium payments are generally non-deductible. 3. Consider amending the valuation provisions of the Agreement in a manner which could effectively exclude the value of Company-owned life insurance from the value of the Company. 4. We completed an informal business valuation of the Company based on Company financials. Using several formulas (but excluding book value), the business value ranged from $3,758,696 to $6,530,435. Agreement Provisions Related to Terms of Purchase If life insurance death proceeds are available to the Company, then no less than the amount of these proceeds received by the Company, shall be paid to the estate of a deceased business owner. Insurance death proceeds in excess of the purchase price are to be retained by the Company. The Agreement does not indicate the terms should the purchase price exceed the amount of available life insurance death proceeds. For all other sales occurring under the Agreement, the terms of purchase, at the buyer s option, shall be cash for the full amount due or not less than 20% of the purchase price as down payment with the balance of the purchase price plus interest, paid in equal monthly or quarterly installments over a period not longer than three years. Upon the death of a business owner, life insurance death proceeds must be applied to the purchase price. 1. The parties may wish to compare the likely cash needs of the Company to cash flow upon the occurrence of a buy-sell trigger. If the cash needs are substantial and cash flow limited, the parties may wish to consider provisions for payments over a longer period of time. 2. Life insurance and disability buy-out coverage may be very helpful in matching cash needs with cash flow. 3. Since the Company is taxed as an S Corporation, and it has adopted an entity purchase buy-sell plan design option, consider acquiring Company-owned, cash value-oriented life insurance policies. This approach could help to reduce the negative impact on owner cost basis due to the payment of term life insurance premiums as a non-deductible expense. The cash value of Company-owned policies may be used as a partial sinking fund for lifetime buy-outs. 4. Consider amending the Agreement to include provisions regarding disposition of life insurance death proceeds in excess of the purchase price under the Agreement. from The Principal Page 6 of 9

7 5. Consider amending the Agreement to include provisions regarding installment payments, with interest, where available life insurance death proceeds are less than the purchase price. 6. Since insurance-funded periodic disability buy-out benefit payments may end with the death of the insured, it may be advisable for the Company to retain ownership of any life insurance policies on the life of a disabled owner until the installment purchase is completed. Agreement Provisions and other Information Related to Funding of the Purchase Price The Agreement permits life insurance on the business owners. No provisions were found in the Agreement related to disability buy-out insurance on the business owners. 1. The parties may wish to review life insurance and disability buy-out coverage. The amount of insurance available to purchase depends upon the value of the business. Underwriting standards for life insurance and disability coverage are different. 2. Payment because of death or disability may be in a lump sum. Insurance coverage to fund these payments may be helpful. 3. If disability buy-out coverage is purchased, consider using a disability definition in the Agreement which is tied to the definition in the disability buy-out policy. 4. Life insurance death proceeds are only income tax free to an employer if the insurance is properly structured and the employer complies with IRC Section 101(j). Section 101(j) applies to employer-owned life insurance issued or materially changed after August 17, To preserve the favorable income tax treatment of life insurance death proceeds, Section 101(j) compliance requires written notice and signed consent by the insured employee to the placement of life insurance coverage owned by the employer. In addition, annual information reporting (Form 8925) on employer-owned policies is required by IRC Section 6039I. 5. Consider adding provisions to the Agreement which address future ownership of life insurance policies acquired for purposes of the buy-sell arrangement as circumstances change. Many buy-sell agreements include dispositive provisions for the following circumstances: (1) termination of the buy-sell agreement; (2) occurrence of a triggering event; (3) sale of the company; or, (4) termination of the business owner s relationship with the company. If any of the preceding events occur, the business owner may be given the option to purchase his or her policy. In addition, if the departing business owner holds a policy on the remaining business owners, the remaining owners should also be from The Principal Page 7 of 9

8 provided with the right to purchase their policies from the departing owner. A means of determining the purchase price of the policy should also be provided in the Agreement. 6. Revenue Procedure generally provides valuation safe harbors for the transfer of life insurance policies from a business to an employee (including an owner-employee). The general standard of valuation is a policy s fair market value. Generally speaking, fair market value is measured differently for different types of life insurance products and may not be represented by a policy s cash surrender value. The insurance company providing the product is in the best position to provide the measure of fair market value for its products. Transactions between or among business owners are generally not bound by the valuation guidelines of Revenue Procedure A business owner exiting the business under a lifetime triggering event through an installment sale of his or her interest generally should not be afforded an option to purchase the life insurance policy on his or her life until the installment sale is completed. 8. Many business owners have found it advantageous to list all life and disability insurance policies acquired for purposes of the buy-sell agreement on a separate schedule attached to the agreement. Where life insurance policies are concerned, this practice has the advantage of not confusing whether death proceeds are to be used for key person needs of the business or to complete the purchase of a deceased owner s business interest. 9. We were not provided with any information regarding the ownership and beneficiary structure of existing insurance. To avoid inadvertent tax consequences and misdirected insurance proceeds, it may be quite helpful to review ownership and beneficiary information with local counsel. 10. Consider with local counsel the advantages and disadvantages of providing a business owner with an unqualified purchase option with respect to a life insurance policy on his [or her] life prior to the policy being disposed of by the Corporation/Company or other business owners. 11. Given the structure of this Agreement, it will be important to periodically update the amount of insurance in force to a level which is roughly commensurate with the value of the business. Agreement Provisions related to Spousal Consent The Agreement has no spousal consent provisions and no signatures blocks for the spouses to sign. from The Principal Page 8 of 9

9 1. The parties may wish to consider adding spousal consent provisions and asking any spouses to sign the Agreement. Parties to the Agreement should discuss with local counsel the impact of including spousal consent provisions for signature. 2. Inclusion of spousal consent provisions and obtaining the signatures of spouses may be helpful in establishing the value of a divorcing owner s interest in the business. This could also help prevent a divorce court from using its own valuation of the business for marital property settlement purposes. Other Agreement Provisions The Agreement does not include either mediation or arbitration provisions. Comment: 1. Consider adding mediation and arbitration provisions to the Agreement. Final Comments and Recommendations Please discuss this report with your tax and legal advisors. Submitted by: James Rockford, CLU Completed by: Pete Leo, J.D., CLU, ChFC, LLIF Reviewed by: Phil Hayne, J.D., CLU WE LL GIVE YOU AN EDGE Principal National Life Insurance Company and Principal Life Insurance Company, Des Moines, Iowa , While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements. Insurance products from the Principal Financial Group (The Principal ) are issued by Principal National Life Insurance Company (except in New York) and Principal Life Insurance Company, Des Moines, IA BB9868SPRES-05 03/2012 t dc from The Principal Page 9 of 9