Buy-sell agreements--an invaluable tool.

EXECUTIVE SUMMARY

* Generally, there are three types of buy-sell agreements--redemption agreements (also called entity agreements), cross-purchase agreements and combination agreements.

* Most buy-sell agreements are activated on the occurrence of a triggering event, such as a voluntary sale, shareholder bankruptcy, divorce, death or disability, irresolvable shareholder disagreement or shareholder retirement.

* Buy-sell agreements can be used to prevent stock ownership disputes, protect S status and otherwise protect shareholder interests.

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Buy-sell agreements can be valuable tools to closely held corporations that seek to protect shareholders' ownership interests and increase the probability of achieving a long and successful operating life. Part I of this two-part article describes the primary forms and common objectives of buy-sell agreements; it also discusses how the agreements operate, including how they are activated, priced and funded and how they affect the selling shareholder's taxes.

Small business owners can use buy-sell agreements to (1) ensure that their interests do not fall into the hands of those with a competing management philosophy; (2) encourage the retention of current employee-shareholders; and (3) create a market for their previously unmarketable stock. These increasingly popular restrictive agreements can be valuable tools to closely held corporations that seek to protect shareholder ownership interests and increase the probability of achieving a long and successful operating life.

Part I of this two-part article describes the primary forms and common objectives of buy-sell agreements; it also describes how they operate, including how they are activated, priced and funded and their effect on the selling shareholder. Part II, in the May 2003 issue, will describe the tax ramifications on the buyer and the remaining shareholders, then highlight the advantages and disadvantages of each type of agreement.

Definitions

Generally, there are three types of buy-sell agreements: redemption agreements (also called entity agreements), cross-purchase agreements and combination agreements. Each Type of stock-transfer agreement has its respective advantages and disadvantages; shareholders should decide the objectives they intend to achieve through the agreement before they choose the particular type to employ. Choosing the appropriate form of buy-sell agreement is critical to ensure shareholders' objectives are met.

The most common type of buy-sell agreement is the redemption agreement. A redemption agreement is an arrangement by which a corporation is obligated (or has the option) to purchase its own stock back from its shareholders on a triggering event (discussed below), such as a shareholder's death or retirement.

In a cross-purchase agreement, the remaining shareholders are obligated (or have the option) to purchase a departing shareholder's stock on the occurrence of a specified triggering event.

A combination agreement has characteristics of both a redemption agreement and a cross-purchase agreement. Specifically, on the occurrence of a triggering event, the corporation has the primary obligation or option to purchase the departing shareholder's stock; the remaining shareholders have the secondary obligation or option to purchase that stock.

Motivations

Before entering into a buy-sell agreement, the shareholders must identify the corporate and shareholder goals that they want to achieve. They should then weigh the costs and benefits of each type of stock-transfer agreement. While the type of agreement that the shareholders choose may be motivated by the tax treatment that each agreement receives, how the stock purchase will be funded is also a significant consideration.

Funding

Because each type of buy-sell agreement either requires or provides the corporation or the remaining shareholders with an opportunity to purchase a retiring shareholder's stock, the purchasing party (or parties) must have funding in place to finance the purchase. However, without adequate planning, most businesses and/or shareholders would not likely have sufficient liquid assets to make such a purchase. Consequently, insurance (most commonly, life insurance) is often used to fund both redemption and cross-purchase agreements.

When closely held corporation shareholders are trying to decide whichtype of buy-sell agreement to enter into, the funding issue can be the deciding factor. If they enter into a redemption agreement, the corporation, rather than the shareholders, will be responsible for purchasing the policy and paying the premiums. In a cross-purchase agreement, the shareholders must secure funding. Having the corporation provide the funding for the stock purchase is often the preferred choice; as a result, a redemption agreement is frequently used.

Objectives

There are many reasons for closely held business owners to want a buy-sell agreement. For example, the loss of one shareholder due to death or retirement can seriously jeopardize the organization's continuing operations. To protect against this threat, shareholders can create a stock-transfer agreement; on a triggering event, the departing shareholder's stock is redeemed by the corporation or purchased by the remaining shareholders. In each case, some or all of the remaining shareholders' interests are increased--proportionally if a redemption agreement is used, or by a function of the number of shares purchased if a cross-purchase agreement is used. This ensures that control of the company remains with the historic shareholders and that the organization does not suffer from conflicting management philosophies.

Preventing Stock Ownership Disputes

Stock-transfer agreements can also reduce any confusion that may result because of questions as to stock ownership on a shareholder's death; if a shareholder dies intestate, it may be unclear who takes the decedent's stock. While the estate administrator essentially holds the stock during probate, the remaining shareholders may not be able to make the decisions necessary to keep the organization functioning smoothly.

For example, many businesses have provisions in their charters that require a certain percentage of shareholder votes before the corporation can take a particular action; the loss of one shareholder with significant voting power can reduce the number of shares of active voting stock below the required threshold. With a buy-sell agreement in place, the remaining shareholders know to whom the stock of a deceased shareholder will go at death; as a result, the corporation will not be "held hostage" during probate.

Protecting Shareholder and Family Interests

A major shareholder's death can also spark concerns within a corporation, because shareholders often leave stock to family members. Frequently, the shareholders are the primary employees; remaining shareholders may be concerned that inexperienced family members will acquire control of the business. Buy-sell agreements can overcome this problem, by keeping stock in the hands of the employee-owners who are knowledgeable about the business's operations and in tune with the historical shareholders' management philosophy.

Buy-sell agreements can also be beneficial to the decedent's family members. The stock of closely held businesses tends to lack ready marketability. Unlike the shareholders of publicly traded corporations, the shareholders of such small corporations cannot convert their business interests into cash simply by arranging a sale through their broker. These shareholders typically have very few options when deciding how to liquidate inherited stock. Buy-sell agreements can establish a ready market and price for the stock. This is particularly important to families of a shareholder who owns a minority interest, because inheriting a minority interest can be of relatively little value compared to the controlling interest in the business. Redemption agreements allow the deceased shareholder's heirs to receive a predetermined amount in exchange for the potentially undervalued business interest they have inherited.

Protection of S Status

Another reason for a stock transfer agreement is to protect S corporation status. Under Sec. 1361, an S corporation must have (1) no more than 75 shareholders, (2) only individuals, estates, trusts and certain exempt organizations as shareholders, (3) no nonresident aliens (NRAs) as shareholders and (4) only one class of stock. While the death of a shareholder alone would not threaten the single-class-of-stock constraint, it could potentially endanger S status, by violating one or more of the other three requirements.

For example, on death, a shareholder could leave his or her shares to a number of individuals and increase the number of shareholders beyond the 75-person limit. In addition, a decedent shareholder could unknowingly leave his or her shares to a NRA. Either occurrence would cause an involuntary termination of the S election and loss of favorable S tax treatment. Buy-sell agreements can prevent this from occurring, by controlling the fate of a shareholder's shares at death.

Foreclosing Shareholder Disputes

Closely held businesses may also enter into a buy-sell agreement to help resolve potential shareholder disputes or if shareholders have a tendency to disagree about the direction the business should take. Such an agreement can state that an unresolvable disagreement among shareholders will trigger the stock-transfer agreement. Thus, with the aid of a buy-sell agreement, an organization can improve its likelihood of long-term survival in the face of feuding shareholders.

Protection from Creditors

Finally, an organization could enter into a buy-sell agreement to protect a shareholder's stock from creditors. An insolvent shareholder can present a risk to a closely held business. Without proper protection, a creditor could gain access to a shareholder's stock on his or her bankruptcy. For this reason, buy-sell agreements are frequently triggered by a shareholder's insolvency. If drafted properly, these agreements can prevent the shareholder's creditors from gaining an ownership interest in the corporation.

Operation

The operation of most buy-sell agreements in closely held corporations is fairly straightforward. On the occurrence of a triggering event, either the corporation or the shareholders (depending on the type of agreement) have the option or the obligation to purchase the departing shareholder's stock. Triggering events can take many forms, including voluntary sales, shareholder bankruptcy, divorce, death or disability, irresolvable shareholder disagreement and shareholder retirement.

Triggering Events

The nature of the particular triggering event can be significant; it is often the controlling factor in determining a buy-sell agreement's price and other terms. For instance, the buy-sell agreement may be structured to encourage a shareholder's continued employment and discourage employee misconduct. This can be accomplished by setting a high price for a stock-transfer agreement triggered by the employee-shareholder's retirement after a number of years of employment, and setting a low price for a buy-sell agreement triggered by an employee-shareholder's termination due to poor performance or misconduct. Thus, like highly publicized stock options, buy-sell agreements can also serve to encourage productive business behavior by employee-shareholders.

The nature of the triggering event can also dictate whether the corporation or remaining shareholders have the option or are required to purchase the departing shareholder's stock. For example, when the triggering event is the shareholder's death or retirement, the corporation or the other shareholders are often required to purchase the departing shareholder's stock. However, when the triggering event is a voluntary sale of a shareholder's stock, the purchasing party or parties are not ordinarily required to purchase the stock; the corporation or the remaining shareholders usually have the right of first refusal. This feature can encourage a shareholder to remain as an employee. Because of the limited market for closely held stock, the decision to remain with a company until an obligation to buy the stock is created can be very valuable.

Pricing

Because the pricing of a buy-sell agreement can vary depending on the triggering event, an agreement may contain a number of different pricing formulas. While many of the more simple agreements contain a fixed price (based on certain valuation methods, such as multiple of earnings or the corporation's book value) usually set when the agreement is established, other agreements incorporate complex formulas for determining the price of a departing shareholder's interest in the company. Some agreements require that the price be based on an independent appraisal; this calls for an appraiser to determine the stock's value at the time of the required purchase (i.e., following the occurrence of a triggering event). While there are a number of different pricing techniques available, drafters should choose a method that sets a price that will also be accepted as the estate tax value, so that the decedent's estate does not have to recognize gain or loss on activation of the agreement. Further, if the price established by the agreement is artificially low (because of an attempt to reduce estate tax exposure), the IRS may contest it. (1)

Just as the pricing terms may depend on the triggering event, the payment method may depend on the pricing terms. For example, an agreement that sets a relatively low price may be funded directly by a company or shareholder, while alternative funding sources (e.g., insurance) may be needed for more expensive agreements. Life insurance is most frequently acquired to fund purchases of stock formerly held by a deceased shareholder. However, nonlife insurance policies can be purchased to fund (in whole or in part) other types of agreements containing a variety of triggering events (including shareholder disability or retirement).

Regardless of the triggering event or pricing terms, buy-sell agreements are not required to be included in a corporation's bylaws or articles of incorporation unless voting rights or other terms of stock are affected. However, if they are included, the amendment procedures included in the articles of incorporation or bylaws must be followed to amend the agreement.

Tax Effect on Seller

As discussed above, numerous issues other than tax consequences need to be considered by a corporation and its shareholders before choosing the appropriate type of buy-sell agreement. Nonetheless, the selection of a particular form of buy-sell agreement often heavily depends on the tax consequences of each choice.

Redemption Agreement

When a redemption agreement is activated, the proceeds are either treated as a dividend under Sec. 301 or accorded sale or exchange treatment under Sec. 302 or 303. If the redemption proceeds are treated as a dividend, they are taxed as ordinary dividend income to the former shareholder to the extent of the corporation's current and accumulated earnings and profits (E&P). Under Sec. 301(c), amounts received in excess of E&P are treated as a return of capital to the shareholder to the extent of basis, and are tax free. Any amount in excess of both E&P and the shareholder's basis is treated as capital gain to the redeeming shareholder (assuming the stock was a capital asset in the shareholder's hands).

Because of the relatively higher income tax rates currently applicable to dividend income, most taxpayers would prefer that a redemption be treated as a sale or exchange of stock, to which the capital-gain rates apply. Further, if the redemption is treated as a sale or exchange, the sales proceeds are offset by the stock's basis for purposes of calculating the gain recognized. As a result, most stock redemption agreements are structured to ensure sale or exchange treatment when the stock is redeemed. This requires strict adherence to the Sec. 302 or 303 requirements.

Dividend or Sale?

Secs. 302 and 303 identify five types of redemptions accorded sale or exchange treatment. If the requirements of one of these provisions are not met, the redemption is treated as a dividend under Sec. 302(d), by default. Four exceptions to dividend treatment are set forth in Sec. 302(b); the fifth is found in Sec. 303.

Not essentially equivalent to a dividend: The first exception to dividend treatment, in Sec. 302(b)(1), applies if the redemption is "not essentially equivalent to a dividend." While the Code provides little clarity in determining the type of distribution deemed not essentially equivalent to a dividend, the regulations provide some insight. Regs. Sec. 1.302-2(b) states that "the question of whether a distribution in redemption of stock of a shareholder is not essentially equivalent to a dividend ... depends upon the facts and circumstances of each case." However, it also states that generally, all distributions in pro-rata redemption of part of a corporation's stock will be treated as dividends, as will a redemption of all of one class of stock. Further, as established by the Supreme Court, a redemption will not be essentially equivalent to a dividend if there has been a "meaningful reduction of the shareholder's proportionate interest in the corporation." (2)

Substantially disproportionate redemption: The second exception to dividend treatment, found in Sec. 302(b)(2), is a "substantially disproportionate redemption." For a distribution to be deemed substantially disproportionate, three conditions must be met: (1) the shareholder must hold less than 50o/6 of the total combined voting power of all classes of stock entitled to vote; (2) the ratio of voting stock held by the shareholder immediately after the redemption must be less than 80% of the shareholder's interest before the redemption; and (3) the shareholder's ownership of the common stock must meet a comparable 80% test.

While this formula is relatively straightforward, the calculations are complicated by the fact that Sec. 318 constructive ownership rules apply. These rules generally require that stock owned by a stockholder's immediate family member, by a partnership, estate or trust, or by a corporation in which the stockholder maintains at least a 50% ownership, is deemed held by the shareholder.

Redemption of entire interest: The third exception to dividend treatment, in Sec. 302(b)(3), is available when a shareholder terminates his or her entire interest through a stock redemption; sale or exchange treatment will result. While, in general, the constructive ownership rules apply in determining a complete termination, the Sec. 318(a) (I). family attribution rules do not apply if several conditions are met under Sec. 302(c)(2):

1. The former shareholder cannot hold or acquire (except by bequest or inheritance) an interest (except for that of creditor) in the corporation for at least 10 years following the redemption (this includes an interest as an officer, director or employee).

2. The former shareholder must retain all necessary records pertaining to the redemption for the 10-year period, and must file an agreement notifying the IRS of any prohibited interest acquired during this period.

3. If the former shareholder acquires such an interest within the restricted period, the limitation periods for making an assessment and collection by levy or court proceeding set forth in Secs. 6501 and 6502 include one year immediately following the date on which the distributee notifies the IRS of the acquisition.

In addition, to obtain sale or exchange treatment, no portion of the redeemed stock may be acquired (or owned at the time of distribution), directly or indirectly, within the 10-year period before the distribution date by a person whose stock ownership would be attributable to the distributee under Sec. 318(a). However, if the distributee's acquisition (or ownership) did not have the avoidance of Federal tax as one of its principal purposes, sale treatment still applies.

Partial liquidation: The fourth exception to dividend treatment for a redemption is met when it is in partial liquidation of a noncorporate shareholder's interest. However, this provision generally does not apply in buy-sell agreements; a partial liquidation normally involves a corporate contraction unrelated to a shareholder need to redeem stock.

Estate expenses: The fifth exception is provided in Sec. 303(a). Distributions in redemption of stock up to the amount of death taxes and funeral and administration expenses incurred by an estate are accorded sale or exchange treatment. For Sec. 303 to apply, the stock must be held by the estate or by heirs who are liable for the death taxes and other administration expenses. Under Sec. 303(b)(2), the distribution must also exceed 35% of the excess of the value of the gross estate over the sum of the amounts allowable as a deduction under Secs. 2053 and 2054.

Cross-Purchase Agreements

While redemption agreements must be carefully drafted to ensure that the shareholder receives favorable tax treatment, cross-purchase agreements usually do not present as many problems. Because a shareholder's stock in a corporation is, in most cases, a capital asset, the selling shareholder will have a capital gain or loss on the sale of his or her stock via the agreement. Whether that gain or loss is considered short- or long-term will be determined by the shareholder's holding period for the stock. A shareholder will receive Capital-gain treatment regardless of the triggering event that invokes the buy-sell agreement. However, if the triggering event is the shareholder's death, Sec. 1014 will apply, causing the stock's basis to be stepped up to fair market value (FMV) as of the date of death (DOD). As a result, the shareholder's estate or heirs will likely realize a relatively small gain or loss on the stock disposition as long as the purchase price was carefully established (and the stock's FMV at the DOD was accurately estimated) when the buy-sell agreement was set.

Conclusion

Buy-sell agreements can be a valuable tool to closely held corporations and their shareholders. These agreements can be drafted in a variety of ways, depending on the desired results. They can be helpful both in protecting an ownership interest from a shareholder's creditors and in aiding shareholder estate planning, by providing a market and a price for the stock on death or disability.

Buy-sell agreements may also protect S status. In addition, they can be triggered by anything from a shareholder's death to an irresolvable shareholder dispute.

Part II, in the May 2003 issue, will describe the tax effect on the buyer and the remaining shareholders and highlight the advantages and disadvantages of each type of agreement.

(1) See Est. of Jephson, 87 TC 297 (1986).

(2) Maclin Davis, 397 US 301 (1970).

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