Buy-sell agreements: an invaluable tool.

Shareholders of closely held corporations should collectively decide which type of buy-sell agreement is appropriate to meet their goals. Part II of this article summarizes the tax effects of common types of agreements on the corporation, the buyer and continuing shareholders and the advantages and disadvantages of each type of agreement. It also identifies some common problems that arise in drafting buy-sell agreements, and how to avoid them.

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Owners of closely held corporations need to decide which type of buy-sell agreement is appropriate to meet their goals. In so doing, shareholders must consider both tax and nontax consequences and other features, such as who will be responsible for financing the stock purchases. Part I of this two-part article described the primary forms and common objectives of buy-sell agreements. Part II, below, considers the tax ramifications of each type of agreement on the corporation, the buyer and the remaining shareholders, as well as advantages and disadvantages. It also shows how to handle some common problems associated with buy-sell agreements, such as Sec. 302 sale and exchange requirements, constructive dividends and valuation problems.

Tax Effect on Buyers and Continuing Shareholders

Although the effect of a buy-sell agreement on a selling shareholder receives a great deal of attention, stock-transfer agreements also affect the corporation and the remaining shareholders. For this reason, shareholders of a closely held corporation must collectively decide which type of buy-sell agreement meets their needs, and analyze the likely results of choosing a particular agreement.

Redemption Agreements

Sec. 311 provides that if a corporation distributes the proceeds of a redemption agreement to its shareholders in a form other than appreciated property, it will not recognize gain or loss, regardless of whether the redeeming shareholder receives dividend or sale or exchange treatment. However, if it distributes appreciated property in exchange for an individual shareholder's stock, the corporation must recognize gain to the extent that the distributed property's fair market value (FMV) exceeds its adjusted basis.

When a corporation distributes either money or property in exchange for its stock, its earnings and profits (E&P) account is reduced by the amount of cash and the property's FMV, under Sec. 312(a) and (b). If the basis of property distributed exceeds its FMV, the corporation's E&P is reduced by the property's adjusted basis. However, if the redeeming shareholder treats the distribution as a sale or exchange under Sec. 302 or 303, the E&P reduction is subject to Sec. 312(n)(7) limits.

In spite of the corporation's treatment resulting from a redemption agreement distribution, the only affect the transaction has on the continuing shareholders is to increase their ownership percentage. If the corporation purchases a shareholder's stock that the buy-sell agreement required the continuing shareholders to purchase (i.e., a cross-purchase agreement), the continuing shareholders will have received a constructive dividend. (1)

Cross-Purchase Agreement

A shareholder's purchase of stock under a cross-purchase agreement is like any other taxable property transaction under Sec. 1001. The principal advantage of a cross-purchase agreement is its relative simplicity (e.g., not having to be concerned with potential dividend treatment to the seller, in the case of a redemption agreement). When a shareholder purchases the stock of another shareholder, he or she receives a cost basis in the shares acquired and the seller has to recognize gain or loss. If the buyer later disposes of this stock in a taxable transaction, the gain or loss he or she realizes is the difference between the cost basis and the amount he or she realized on the disposition.

The shareholder must weigh the simplicity of a cross-purchase agreement against the requirement to fund the purchase. Because of this, a continuing shareholder would most likely prefer a redemption agreement.

Choosing an Agreement

Each type of buy-sell agreement has both tax and nontax consequences. The primary nontax concern is who will be responsible for securing financing to implement the agreement. In a cross-purchase agreement, shareholders must either finance the purchase themselves or pay the premiums for the insurance policy that effectuates the stock purchase. In a redemption agreement, the corporation is responsible for having sufficient financing in place to carry out the redemption agreement. Consequently, redemption agreements would ordinarily be favored over cross-purchase agreements if the concerned parties were neutral as to the tax consequences. However, this rarely happens.

Cross-purchase agreements almost always result in the selling party (i.e., the departing shareholder) recognizing a capital gain or loss; the corporation itself is unaffected by the stock transfer. The remaining shareholders who purchase the departing shareholder's stock take a cost basis; their interests in the corporation increase in proportion to the number of shares purchased under the agreement. If each shareholder has an obligation to purchase a proportionate number of the departing shareholder's shares, the ownership interests would not change relative to one another.

The redeeming shareholders in redemption agreements could receive capital gain treatment on their stock redemption if the transaction complies with Sec. 302 or 303 requirements. Further, under Sec. 1032, the corporation (as the purchaser) does not realize a gain or loss (other than when distributing appreciated property) on its own stock. After it is redeemed, the stock is either treated as treasury stock or simply cancelled. The remaining shareholders' interests are increased in proportion to their interests before the redemption.

The primary tax difference between the two types of buy-sell agreements from the continuing shareholder's perspective is the transaction's effect on the basis in the purchased (or redeemed) stock. In a cross-purchase agreement, a continuing shareholder's basis in the stock increases by the purchase price of the acquired stock. In a redemption, however, the basis of the continuing shareholder's now-higher percentage of the corporation's equity does not change. The basis difference, however, does not lead to a difference in gain or loss realized on a subsequent taxable disposition. (2)

Perhaps the sole tax advantage of a cross-purchase agreement is that it does not require tax advisers to carefully comply with Secs. 302's and 303's requirements when drafting the agreement; they need not ensure that the departing shareholder receive sale or exchange treatment on activation of the agreement. Thus, shareholders must ultimately decide if being responsible for funding the buy-sell agreement themselves is worth the seller's favorable tax treatment.

Pitfalls

Improperly structured buy-sell agreements can produce undesired and unintended results.

Sometimes, inexperienced practitioners will draft a stock-transfer agreement such that it subjects either the buying or the selling party to unnecessary tax.

Sec. 302

Some of the more common errors tax advisers make when creating agreements involve Sec. 302 violations. For example, redemption agreements can call for a sale of less than 100% of a shareholder's interest in a company (e.g., when an active shareholder wants to retire, but maintain a reduced interest). However, the Sec. 302(b)(2) substantially disproportionate requirement will not be met if, immediately after the redemption, the selling shareholder retains a 50%-or-greater interest in the combined voting power of all classes of stock entitled to vote. In addition, the Sec. 302(b)(2) requirements will not be met if the shareholder retains an interest in the stock equal to, or in excess of, 80% of the stock that he or she held before the redemption (in measuring these interests, Sec. 318 constructive ownership rules apply). On failing the Sec. 302(b)(2) requirements, the redeeming shareholder's distribution will be taxed as dividend income, assuming one of the other redemption provisions is not met.

Sec. 302(b) problems could be easily avoided when a shareholder's death triggers the buy-sell agreement if the redemption proceeds are limited to the amount of the shareholder's estate tax and/or funeral and administration expenses. In such a case, Sec. 303 treats the transaction as a sale or exchange, regardless of the ownership percentage retained by heirs or other related parties.

Constructive Dividends

Another common pitfall drafters of buy-sell agreements must avoid involves cross-purchase agreements. If a cross-purchase agreement provides that continuing shareholders have a primary and unconditional obligation to purchase shares on a triggering event, but the corporation purchases the stock instead, the purchase becomes a constructive dividend to the continuing shareholders. (3) In a properly structured redemption agreement, the continuing shareholders are not directly affected by the purchase (except for an increase in their ownership percentages).

Another way tax advisers can avoid this problem is by structuring the agreement so that shareholders have an option to purchase the stock, rather than an unconditional obligation to do so. If, however, the drafter already committed this mistake, the shareholders can assign their purchasing obligation to the corporation. This will transform a stock-transfer agreement into a redemption agreement, and eliminate a constructive dividend, as long as the shareholders assign their obligation to the corporation before incurring a primary and unconditional obligation to pay for the shares. (4)

Valuation

An additional pitfall that frequently plagues buy-sell agreements is valuation. When a tax adviser creates a buy-sell agreement, he or she often has difficulty determining the value of a shareholder's interest at an undetermined point in the future. As a result, some agreements that merely provide the remaining shareholders or the corporation with an option to purchase the departing shareholder's stock never take effect, because the parties cannot decide on a selling price. Thus, it is important for the agreement to describe how the stock will be valued on a triggering event.

Some agreements set a price for the stock when the agreement is entered into; more often, agreements provide a formula or other method that will be used to value the corporation's stock on a triggering event. These formulas can be based on a number of factors; the most common are typically a function of the corporation's current or projected earnings, book value or liquidation value of the firm's assets. The formulas also regularly contain a discount factor for lack of marketability, because the value of a closely held corporation's stock on the open market is significantly lower than the value of a firm's assets (particularly that held by a minority shareholder). Other techniques for valuing a shareholder's stock include negotiation between the buying and selling parties and an independent appraisal.

Conclusion

Buy-sell agreements can be a valuable tool to closely held corporations and shareholders who want to protect their ownership interests and increase the probability of a long and successful operating life. Because a simple agreement can be drafted to include only one triggering event and a straightforward pricing method for future stock purchases or redemptions, such agreements can be created rather quickly (and relatively inexpensively). However, if drafted improperly, these agreements can cause both the buying and selling parties a number of problems. To ensure that the agreement is drafted correctly, the interested parties should consult an accountant and/or attorney experienced in corporate tax and buy-sell agreements.

EXECUTIVE SUMMARY

* In deciding which type of buy-sell agreement to employ, owners must consider both tax and nontax features, such as who is responsible for financing the stock purchases.

* If improperly structured, buy-sell agreements can produce undesired and unintended results, including unnecessary tax.

* Some common pit-falls to avoid include noncompliance with Sec. 302 requirements for sale and exchange treatment, constructive--dividend treatment in cross-purchase arrangements and future valuations of the interests to be purchased or redeemed.

For more information about this article, contact Mr. Jackson at [e-mail] or Dr. Maloney at [e-mail].

(1) Rev. Rul. 69-608, 1969-2 CB 42.

(2) Regardless of whether the buy-sell agreement is structured as a redemption or cross-purchase, the subsequent taxable sale of the equity interest by the continuing shareholder would produce an equivalent amount of gain or loss. This assumes that corporate funds used for a redemption would cause a corresponding decrease in the value of the stock.

(3) Rev. Rul. 69-608, note 1 supra.

George Jackson III, MS, J.D.
Attorney
Jenkens & Gilchrist, PC
Washington, DC

David M. Maloney, Ph.D., CPA
Professor of Commerce
McIntire School of Commerce
University of Virginia
Charlottseville, VA