The importance of buy-sell agreements for closely held corporations. (Estates & Trusts)

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1 Page 1 of 6 The CPA Journal Online Feb 1992 The importance of buy-sell agreements for closely held corporations. (Estates & Trusts) by Cavallaro, Alfred Search Software Personal Help Abstract- The death of a key stockholder can seriously threaten the financial stability of close corporations. A problem is created when the corporation is left without a competent steward. The surviving stockholders may opt to buy the shares of the deceased shareholder, continue conducting business with the heirs of the deceased, or sell their own shares. They may have to deal with new co-owners if the stocks of the deceased are sold to outsiders. Close corporations can deal with these potential problems with a carefully prepared buy-sell agreement, which can either be an entity-purchase or a cross-purchase. The decedent's stocks are acquired by the corporation in an entity-purchase. In a cross-purchase, on the other hand, individual shareholders buy the shares of the deceased. The death of a stockholder in a closely held corporation has an immediate impact on its operations, the remaining stockholders, and the decedent's heirs, if any. Problems for the Corporation Upon death of a shareholder, the corporation may suddenly be without the talents and skills of a key individual possessing management skills that are irreplaceable. The stewardship of the entity may be in jeopardy and the confidence of the clientele may be seriously weakened. Concerns of the Remaining Stockholders The surviving stockholders confront several issues. They may decide to continue the corporate enterprise with the heirs of the deceased shareholder as part of management. On the other hand, the surviving shareholders may want to purchase the stock of the deceased. The price for such an acquisition may be high and the funds to accomplish this unavailable. The remaining stockholders may consider selling their own interest. This strategy may have limited practical use, since an established market for such a sale may not exist and the selling price may not provide the shareholders with what they consider a reasonable return on their investment. If the remaining shareholders expect to continue the operations of the company, they may have to deal with new co-owners who purchase decedent's interest. Once again, the personal attributes, management techniques, and ownership goals of the new purchasers may clash with those of the remaining shareholders.

2 Page 2 of 6 Goals of the Heirs of the Deceased Stockholder The heirs of the deceased stockholder may wish to dispose of the stock in order to enhance the liquidity of the decedent's estate. However, they may be surprised to learn that neither the corporation nor the remaining shareholders have the financial capability of engaging in such an undertaking. In addition, finding outsiders interested in buying the stock may prove to be time-consuming and unrealistic. In this scenario, the heirs will have no choice other than to retain the stock and play an active role in the business, while finding an alternate source of funds to pay estate taxes and administration expenses. How to Avoid These Multiple Problems The proven mechanism for dealing with these issues is the buy-sell agreement. A carefully drafted agreement is a valuable tool that can ensure the financial security of the corporate owners and their families. At the same time, the buy-sell agreement allows the business to continue in a normal manner with a qualified and motivated management group at the helm. The specific provisions of the buy-sell agreement must be tailored to satisfy the needs and objectives of the individuals and the corporation. The general goals, however, are to provide the cash so that the decedent's interest in the company may be purchased and the mechanism so that the business may continue to operate smoothly. Valuation Considerations Of paramount importance in drafting a buy-sell agreement is providing for the value of each shareholder's interest in the business and determining what price is to be paid for such interest. To be useful for estate tax valuation purposes, the agreement should contain a mechanism to establish the value of the business which will apply to all dispositions of a shareholder's ownership interest. The buy-sell agreement may fix the value of the business by consent of the parties at a predetermined price, approximating fair market value, or by formula. If the parties agree upon a specific value, then the agreement must further provide that the parties will periodically reexamine the corporation's value and certify any changes in such value. The professional services of an appraiser and/or CPA will be needed each time a revaluation is done. It is therefore advisable for the draftsman to provide for a contingent method of valuation such as a price formula. One popular approach is to capitalize net earnings by multiplying a five-year average by an appropriate factor (i.e., five or 10 times). It is also possible to use the book value or net asset value of the company. The use of book value may be recommended for a service business that is not capital intensive. However, if a company has a balance sheet consisting of a large percentage of fixed assets such as real estate, machinery, equipment, or other assets recorded at historical cost values that are significantly different from fair market values, then the book value approach would be inappropriate. Other methods of valuation may be implemented by the owners of the corporation. It must be remebered that the buy-sell agreement may be in force for many years before becoming operative. The parties should therefore carefully look at economic factors that may change between the time of the agreement's execution and the time of its activation. Types of Buy-Sell Agreements

3 Page 3 of 6 There are two basic types of buy-sell agreements: entity-purchase and cross-purchase. Under the former, the corporation is a party to the contract with the shareholders and the corporation ultimately purchases the decedent's stock. On the other hand, the crosspurchase form of agreement is entered into by the individual shareholders without involvement of the corporation. Given the diverse consequences that follow from the two forms of agreement and the resulting decisions that must be made, the draftsman may be unable to advise the parties which form of agreement is most appropriate at the time the agreement is executed. To resolve this dilemma, the agreement may be structured so that the decedent's estate must sell his or her interest in the business leaving the surviving shareholders with the option of purchasing the decedent's interest directly or directing that it be purchased by the corporation. This arrangement should be effective without any negative tax problems provided the funds used to make the purchase are received from the party actually acquiring the decedent's stock. For example, an unwanted dividend may result where the corporation makes a cash distribution to a surviving shareholder who must then use the funds to purchase the decedent's interest. One may avoid this situation by giving proper attention to the funding of the agreement. Funding A buy-sell agreement will have no practical benefit unless the purchaser can finance the purchase price. The purchase price can be paid in a number of ways. Existing assets of the purchaser may be used, although this may cause a financial strain on the purchaser, resulting in the liquidation of assets at an inopportune time. The funds can be borrowed if the purchaser has good credit and is capable of paying the interest incurred. Provision can also be made for installment payments of the purchase price, but this will require periodic outlays on the part of the purchaser. Life insurance is often an ideal method of funding a buy-sell agreement. Premiums are relatively inexpensive and cash outlays are predictable. The cost of the life insurance premiums will not adversely affect the working capital or credit of the purchaser, and it is easy to administer. The use of a buy-sell agreement funded by life insurance allows the heirs of the deceased shareholder to receive cash in exchange for stock. If properly drafted, the agreement will provide for an immediate purchase of the decedent's interest at a reasonable price. The heirs will benefit because the decedent's estate will have an infusion of cash to pay estate and inheritance taxes as well as administration expenses. By funding the buy-sell agreement with life insurance, the viability of the corporate entity as a going concern will be clearly established. The banks and lending institutions will be more inclined to provide favorable financing. The corporation will furthermore be able to engage in long-term business transactions and contracts because customers, suppliers and developers will be confident of its financial stability. The corporate employees will also be impressed by the corporation's smooth transition and they may perceive that their employer is well suited for future growth and opportunities due to good management and sound planning. Tax Implications IRC Sec provides that the basis of property acquired from a decedent is the property's fair market value on the date of the decedent's death or the alternative valuation date, whichever is applicable. Where the parties use the entity-purchase form of buy-sell agreement, the surviving shareholder will not receive a step-up in his or her basis for the value of decedent's interest in the business. On the other hand, if the cross-purchase form of agreement is used, the

4 Page 4 of 6 surviving shareholder will receive a step-up in basis equal to the purchase price of the decased shareholder's interest. Assume, for example, that a corporation was formed in 1950 by X and Y, and each contributed $30,000 of capital. Further, assume that X died on January 1, 1990, and his interest in the corporation was worth $400,000. If the corporation redeems K's stock, then Y's basis for the stock shares will remain at $30,000. If, however, a cross-purchase form of agreement was used, then Y's basis would have increased to $430,000 ($400,000 + $30,000). Upon a subsequent sale by Y of all his stock for $900,000, he would realize a capital gain of $870,000 under an entity- purchase agreement and a capital gain of $470,000 under a cross-purchase agreement. Additionally, if the entity is an S corporation, then the increased basis of the surviving shareholder's interest will enable him to deduct a greater amount of pass-through losses as allowed under Sec. 1366(d). Corporate Redemptions An entity-purchase form of buy-sell agreement results in a corporate redemption since the corporation, in essence, redeems the decedent's stock. This raises the issue of ensuring that the decedent's estate avoids having to treat the distribution from the corporation as a dividend. Secs. 302 and 303 provide shelter from dividend treatment. When a redemption occurs upon the death of a shareholder, Sec will operate to increase the estate's basis in the decedent's stock to fair market value. Therefore, a distribution treated as an exchange will result in a tax-free transaction whereas if dividend treatment is imposed the transaction will be fully taxable. The provisions of Sec. 303 will treat the redemption as an exchange to the extent that the distribution does not exceed general and administration expenses and estate taxes. Any excess must come under the provisions of Sec. 302 to escape taxation. The attribution rules of Sec. 318 of the Code, however, may present a barrier to Sec. 302 exchange treatment. Sec. 302(b)(3) states that exchange treatment "shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder." If the decedent and the surviving shareholder are related, the latter's stock may be attributable to the estate of the decedent. This would prohibit exchange treatment, thereby causing the distribution to be taxable to the estate and nondeductible by the corporation. To avoid this problem, it is imperative that the surviving related- shareholder does not have a direct interest in the property held by the estate or the income there from at the time of redemption. In advising clients with this problem, the draftsman should suggest that lifetime gifts be made to the related shareholder or that a cash legacy or specific bequest be made to such person that can be satisfied prior to redemption. The draftsman should also consider whether a cross-purchase form of agreement may be more appropriate. Advisors must also be aware that as of 1990, insurance proceeds received under an entitypurchase agreement may be subject to the newly enacted alternative minimum tax provisions of the IRC. Secs. 2036(c) and 2703 Before the enactment of Sec. 2036(c) in 1987, it was generally accepted that the IRS would recognize the purchase price set in a buy- sell agreement; provided, however, the agreement was a bona fide business arrangement and not a method of transferring a shareholder's interest to the objects of his or her bounty for less than fair market value. The following provisions were required for the agreement to be binding for federal estate tax purposes:

5 Page 5 of 6 1. The decedent's estate had to sell his or her stock and a surviving shareholder or the corporation had to buy or had to have an option to buy said stock; 2. The agreement had to restrict the shareholders from transferring their shares during their lifetimes; and 3. The purchase price agreed upon had to be reasonable at the time the agreement was executed. RRA 90, signed into law on November 5, 1990, repealed the anti-freeze provisions of Sec. 2036(c) retroactively to its original date of enactment, December 17, 1987, and replaced it with new Chapter 14 effective for transfers after October 8, Sec. 2703, which covers buy-sell agreements, requires the value of property for transfer tax purposes to be determined without regard to any option, agreement or other right to acquire or use the property at less than fair market value or any restriction on the right to sell or use the property, unless the option, agreement, right or restriction meets three requirements. The buy-sell agreement must: * Be a bona fide business arrangement; * Not be a device to transfer property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and * Have terms that are comparable to similar arm's length agreements. These rules apply to buy-sell agreements executed after October 8, 1990, as well as to agreements that are substantially modified after that date. This could present a problem where new owners enter a business and an existing buy-sell agreement must be modified. One way to resolve this issue is to create a separate agreement for the new owner, provided, however, that the IRS is not able to treat the separate agreement as a modification of the existing agreement. Other Issues If it is decided that the earnings of a corporation will be accumulated and used to fund the buy-sell agreement, the draftsman should be aware of the possible applicability of the accumulated earnings tax imposed under Sec Additionally, where appreciated assets of the corporation are used to redeem the deceased shareholder's shares, Sec. 311(b)(1) may act to require the corporation to recognize gain for the difference between the basis of the amounts distributed and their fair market value. The advisor should inform his or her clients that Sec. 264(a)(1) will prevent premiums paid on a life insurance policy from being deductible under both entity purchase and cross- purchase form of agreement. Moreover, unlike payments made under partnership buy-sell agreements, payments made in connection with a corporate buy-sell agreement generally do not result in income in respect of a decedent unless the sale occurs before the shareholder's death and the proceeds are received by the estate after death. Finally, when dealing with an interest in an S corporation, the agreement must be prepared with an eye toward maintaining that status. If one of the shareholders, for example, bequeaths his or her interest to a nonqualifying trust, the S election will lapse. Disability Provision The shareholders should also include a provision in the buy-sell agreement to deal with the possibility of long-term disability of one of the owners. The absence of an owner can affect the business concern just as seriously as the owner's death. By including a disability clause in the buy-sell agreement, the company will have the necessary protection against

6 Page 6 of 6 such an event. A key-person disability insurance policy can protect and enhance the goals o sell agreement. This need can also be funded by purchasing disability buy-out insurance. Home Contact Subscribe Advertise Archives NYSSCPA The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, m educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other a professionals with the information and news to enable them to be successful accountants, managers, and executives practice environments The CPA Journal. Legal Notices

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