Summary of Buy-Sell Agreement Issues
Questions and Answers
[Chris Mercer – Buy Sell Agreements]
| The type of agreement. Which type is desired? Funding, taxes and cost basis are all affected by the type of agreement. | Yes | No |
| Cross Purchase Agreements (Shareholders agree to purchase shares) | ||
| Redemption Agreements (Corporation agrees to purchase shares) | ||
| Hybrid (Combination) | ||
| ESOP (ESOP used to purchase shares) | ||
| The purchase of shares by the ESOP may result in a deferral on the gain realized on the sale. | ||
| The sponsoring corporation may get increase deductions for the contributions to the ESOP to pay the principal and interest on loans needed to purchase the shares. The ESOP may be able to purchase life insurance on key employees to fund the subsequent purchase but the corporation may not get a deduction for the contributions needed to fund the insurance premiums. | ||
| Triggering events that cause a mandatory or optional buyout. | Yes | No |
| Death | ||
| Disability | ||
| Retirement | ||
| Voluntary Termination | ||
| Termination for Cause | ||
| Divorce | ||
| Bankruptcy | ||
| Mandatory or Optional (The Buy Sell Agreement should clearly state whether the purchase or sale will be mandatory or optional or subject to a first right of refusal.) | Yes | No |
| Should the agreement be structured: | ||
| To require the seller to sell and the buyer to buy? | ||
| To give the buyer an option to require the seller to sell? | ||
| To give the seller an option to require the buyer to buy? | ||
| To give a right of first refusal to the buyer? | ||
| As a combination of any of the above? | ||
| Should the death of an owner cause an automatic buyout of the owner’s interest or should his/her family be allowed to remain as an owner? | ||
| Valuation Date imposed by the agreement. | Yes | No |
| Date of Death | ||
| Disability (Should there be a period of disability before exercising the right to buy out a disabled owner?) | ||
| Retirement | ||
| Termination (allow time for non-compete/non-solicitation restrictions to pass or time to determine the extent of malfeasance?) | ||
| Purchase Price | Yes | No |
| (Is it affected by loss of the employee?) | ||
| (Are insurance proceeds factored into the valuation?) | ||
| Fair Value | ||
| Fair Market Value | ||
| Formula Pricing | ||
| Fixed Price | ||
| Book Value | ||
| Adjusted Book Value | ||
| Value Based on Insurance Proceeds | ||
| Periodic Review and Consensus | ||
| Penalty for Termination for Cause | ||
| Penalty for Violation of Non-compete | ||
| Penalty for Solicitation of Employees | ||
| Terms of payment. | Yes | No |
| Cash | ||
| Promissory Note (Term and Interest) | ||
| Future earnings | ||
| Methods by which the agreement will be funded. | Yes | No |
| Sinking Fund | ||
| Life/Disability Insurance | ||
| Future earnings (Paid over a period of time based on the profitability of the business, so that the more profits the business had, the more it would pay on the outstanding balance. Raises the question of changes in value during period of pay-out) | ||
| Promissory Note | ||
| Term | ||
| Interest | ||
| Security via pledge of shares held by other shareholders or assets of the corporation. | ||
| Vote Restrictions (shares to be redeemed over a period of years may be subject to vote restrictions) | ||
| If funded with life insurance: Should the type of life insurance used be addressed (i.e. term life, ordinary life, last to die, paid-up life, universal life or an endowment policy?) | ||
| Should a life insurance trust be used? | ||
| Should all of the policy proceeds be required to be used to redeem the interest? | ||
| Can part of the proceeds be used to help the entity recover from the loss of the owner? | ||
| Should whole life insurance policies with cash values be transferred to the owner at termination or retirement? | ||
| Non-compete agreements between the parties. | Yes | No |
| Transfers Restrictions | Yes | No |
| First Right of Refusal | ||
| Full Restriction of Transfer | ||
| Permitted transfers to family (define family) | ||
| Vote Restrictions on Family Transfers (see Methods of Payment>Promissory Note) | ||
| Application to New Shareholders | Yes | No |
| Are Buy-Sell Issues in proper alignment with Stock Option Agreement(s), Employment Agreements, ESOP, etc. | Yes | No |
| Are there Restrictions under Loan Agreements on the Use of Business Assets to Redeem Equity Interests? | Yes | No |
| Security (Should the agreement be guaranteed or secured?)
If so, should the security be in the form of: |
||
| A pledge of business assets? | ||
| A personal guarantee by the other owners? | ||
| An agreement obligating the entity to refrain from increasing salaries, paying dividends or making loans until all outstanding liabilities to the beneficiaries are paid? |
| Loans | Yes | No |
| Should the disposition of owners’ loans, whether receivables or payables, in the event of termination because of death or disability be addressed? | ||
| Should the disposition of owners’ loans in the event of termination other than because of death or disability be addressed? | ||
| Other | Yes | No |
| Should an owner have the right to transfer or assign to a trust, for estate-tax planning purposes, their rights and interests in the business? | ||
| Should the spouses of the owners sign the buy/sell agreement? | ||
| Do other family members presently own any stock? | ||
| Applicability | Yes | No |
| Should the agreement apply only to the current owners | ||
| Should it be binding on all owners throughout the life of the business entity? | ||
| Should the agreement provide that it supersedes all other agreements to redeem a business interest? | ||
| Is the agreement being reviewed annually? (Changes of price or terms should require a unanimous vote of the owners.) | ||
| Should an owner have the right to transfer or assign to a trust, for estate-tax planning purposes, their rights and interests in the business? | ||
| Should the spouses of the owners sign the buy/sell agreement? | ||
| Restrictions on Use of Funds | ||
| The obligation to redeem the interest of a deceased owner may affect the entity’s ability to borrow in the future. | ||
| The creditors of the business may have a prior claim to insurance proceeds or other assets designated for the purchaser of the interest when the triggering event occurs. | ||
| In some states a corporation may not redeem its own shares unless there is sufficient capital surplus or retained earning to fund the redemption…or if it would cause the corporation to be unable to pay its debts as they become due…or in some states the surplus must be sufficient to cover the entire purchase price at the time the note is given. | ||
| Tax Issues |
| Corporate Redemption |
| Premium payments are NOT deductible. |
| Generally, life insurance proceeds are NOT subject to income tax unless the policy has been transferred to another person for valuable consideration (Transfer For Value Rule) |
| If a C Corporation is redeeming a shareholder’s shares, any interest paid will be deductible. |
| Alternative Minimum Tax may apply to 75% of the proceeds of a life insurance policy paid to a C corporation. |
| Accumulated Earnings Tax may apply if the C corporation sets aside liquid assets to fund the purchase of shares under a Buy Sell Agreement. |
| Capital gains treatment for the estate of the deceased shareholder may be subject to certain IRS rules. |
| The basis of the shares owned by the remaining shareholders is not increase as a result of the corporation’s purchase. |
| Cross Purchase Agreement |
| Premium payments are NOT deductible |
| A sale to another shareholder (via a cross purchase agreement) will always be a capital gain. |
| Each remaining shareholder obtains a basis in the newly purchased shares equal to the purchase price he or she pays. |
| Other Issues |
| The remaining shareholders may receive tax free proceeds from life insurance policies used to fund the purchase in excess of the required purchase price, which if received by the corporation under a redemption agreement would be trapped in the corporation and would be difficult to distribute to the shareholders without being treated as a dividend if the corporation had earnings and profits. |
| If a redemption agreement grants the entity the option to purchase an owner’s interest, the agreement should be drafted to exclude the withdrawing owner or the estate of a deceased owner from participating in the entity’s decision concerning the exercise of the option. |
| If some of the interests are held by members of the same family, special provisions may be required to ensure that the family group retains the same ownership percentage. |