Reviewing a buy/sell agreement.

Editor's note: This case study has been adapted from "Guide To Tax Planning For Individuals," 4th Edition, by Anthony J. DeChellis, Douglas I. Weinbrenner, Catherine A. Roeder and James F. Reeves, published by Practitioners Publishing Company, Fort Worth, Tex., 1999.

Facts: Martha Smarts co-owns a business with her daughter Elizabeth and her son Tom; each holds 331/3% of the stock. Martha functions as chief executive officer, Elizabeth is chief financial officer and Tom chief operations officer. At 73, Martha is concerned about (1) her ability to continue working in the business day-to-day and (2) business succession after her death. Her attorney drafted a buy-sell agreement for the business; she asks her tax adviser to review it.

Issue: What should a tax adviser look for in a buy-sell agreement?

Discussion

A buy-sell agreement is a contract between the owners of a business that provides for the sale of an owner's interest on the occurrence of an event Ouch as death or disability). Following is a questionnaire and checklist to be used when reviewing a buy-sell agreement.

Checklist for Reviewing a Buy/Sell Agreement

Note: This checklist is intended to help tax advisers review and interpret buy/sell documents for their own benefit, not to advise clients on the legal implications of a contract. Rendering advice on the legal implications of buy/sell agreements constitutes the practice of law.

Client: --        Date Prepared: --

Prepared by:--    Reviewed by: --

                                                     Yes   No   N/A
I. Provisions Binding All Parties, Present and
Future

A. Are all existing owners and the entity itself
named or otherwise specifically identified in the
agreement?                                           --    --   --

B. Have any individuals holding an option to
purchase ownership interests also been included
as a party to the agreement?                         --    --   --

C. Is there a provision conditioning future
acquisitions of ownership interests on the new
owners accepting the agreement's terms and
provisions?                                          --    --   --

D. If spouses are not actual parties to the
agreement, have they at least executed a consent
to its terms and an acknowledgment of how any
disposition of their community property or
marital interest in the entity's ownership will
be handled?                                          --    --   --

II. Valuation Method Alternatives

A. If a fixed value is used:

1. Is it dear how and when the fixed value is to
be determined?                                       --    --   --

2. Is an alternate valuation method provided to
address situations in which the fixed value has
not been changed or reviewed for a certain period
of years?                                            --    --   --

3. Is there a method to break a stalemate if the
owners cannot agree on the value to use in
establishing or updating the agreement?              --    --   --

4. If the fixed value is directly or indirectly
tied to life insurance coverage on the owners,
does this same value apply to triggering events
other than death? If so, the client needs to make
sure the method of funding the buyout after one
of these other events has been addressed, because
life insurance proceeds won't be available in
those circumstances.                                 --    --   --

B. If an appraisal method is used:

1. Does the agreement specify the qualifications
required of the person chosen as appraiser?          --    --   --

2. Is the method for selecting an appraiser
specified? For example, it could be based on (1)
mutual agreement of the parties, (2) each party
selecting an appraiser and the average of the two
appraisals used or (3) each party selecting an
appraiser and the two appraisers then selecting a
third appraiser to actually establish the
business's value.                                    --    --   --

3. Is the issue of who pays for the appraisal
(perhaps depending on the triggering event)
addressed?                                           --    --   --

C. If a formula approach is used:

1. Is the formula for valuing the entity dearly
spelled out in the agreement? For example, just
stating net book value, capitalized earnings or
capitalized net cashflow is not enough. Such
details as the method for determining net book
value (GAAP or tax basis, cash or accrual) or the
capitalization rate to be used are also important.   --    --   --

2. If a capitalization method is used, was
consideration given to the appropriateness of
adding back the owners' salaries and benefits?       --    --   --

3. Does the agreement provide a simple,
cost-effective method for resolving disputes
about the application of the formula?                --    --   --

III. Triggering Events

A. Death of an owner.

1. Is the agreement clear as to whether it is an
option or a requirement that the decedent's
shares be sold back to the entity or other owners?   --    --   --

2. If a Sale is optional:

a. Does the agreement specify who holds the
option (the decedent's heirs or the entity/other
owners)?                                             --    --   --

b. Is there a deadline on the right to
exercise the option? c. Are the procedures for
exercising the option specified (how to give
notice, etc.)?

3. Terms of sale.

a. If the purchase price is funded by insurance
proceeds that prove to be inadequate, is there a
provision for determining how the balance is to
be paid (all at closing or over a period of time)?   --    --   --

b. If a portion of the purchase price will be
paid over time, are there provisions for
determining the payment period, terms of payment
and interest rate?                                   --    --   --

B. Disability of owner.

1. Is the term "disability" adequately defined?      --    --   --

2. When disability occurs, is it dear whether a
sale is mandatory or optional?                       --    --   --

3. If optional, does the agreement specify who
holds the option (disabled owner or the
entity/other owners)?                                --    --   --

4. Does the agreement specify the formula for
determining the purchase price, the deadline for
exercising any option to force or make a sale
and the payment terms?                               --    --   --


C. Involuntary disposition (bankruptcy or
insolvency, etc., of an owner).

1. Is it clear whether a sale is mandatory or
optional?                                            --    --   --

2. If optional, does the agreement indicate who
holds the option (the owner in distress or the
entity/other owners), the deadline for exercising
it and how it is to be exercised (notice
requirements, etc.)?                                 --    --   --

3. Does the agreement specify the formula for
determining the purchase pr. ice, the deadline
for completing a sale and the payment terms?         --    --   --

D. Divorce or death of nonowner-spouse.

1. Does the owner-spouse have the option to
purchase the nonowner-spouse's community property
or marital interest if such interest is not
awarded in divorce or does not pass under the
will?                                                --    --   --

2. If a purchase option exists, but the
owner-spouse fails to exercise it, do the other
owners or the company have the option to buy the
interest?                                            --    --   --

3. Does the agreement specify the formula for
determining the purchase price, the deadline for
completing a sale, notification requirements and
the payment terms?                                   --    --   --

E. Offer by outside third party.

1. Does the entity or the owners or both have a
right of first refusal to purchase the ownership
interests for the same price and terms?              --    --   --

2. If the party with the right of first refusal
(entity or owners) fails to exercise such right,
does the other party then have an option to
exercise a right of refusal?                         --    --   --

3. If a right of refusal exists, can it be
partially exercised, or does the selling owner's
entire interests have to be acquired?                --    --   --

4. Is there a provision requiring notice of any
offer to be delivered to the entity and the other
owners within a specified time?                      --    --   --

5. Is there a deadline by which a right of
refusal must be exercised?                           --    --   --

6. Does the agreement specify the price at which
a right of first refusal may be exercised (for
example, (a) the price offered by the third
party; (b) a formula, fixed value or appraisal
amount or (c) either the lesser or greater of(a)
and(b))?                                             --    --   --

7. If a right of refusal is not exercised, is
the right to use it triggered again if the
third-party sale is not consummated within a
specified time period?                               --    --   --

F. Disagreement among the parties.

1. Is there a "Russian roulette" provision,
allowing any owner to make an offer for the other
owners' interests and requiring the other owners
either to sell at the offered terms or purchase
the offering owner's shares under the same terms?    --    --   --

2. If such a provision exists, is there an
appropriate time frame for responses from both
sides?                                               --    --   --

G. Termination of employment.

1. Is it clear whether a sale is mandatory or
optional?                                            --    --   --

2. If optional, does the agreement indicate
who holds the option (former employee or the
entity/other owners), the deadline for
exercising it and how it is to be exercised
(notice requirements, etc.)?                         --    --   --

3. Does the purchase price vary depending on the
reason for termination? For example, a voluntary
termination might command one price, while a
termination for cause might result in a lower
price.                                               --    --   --

4. If the price varies depending on the reason,
are the reasons dearly defined? For example, if
termination for cause is a triggering event, the
agreement should define cause.                       --    --   --

5. Are the payment terms clearly spelled out?        --    --   --

IV. Security for Payment

A. In the case of a cross-purchase agreement (in
which the other owners, rather than the company,
are responsible for acquiring the selling owner's
interest):

1. If the agreement is funded with insurance, has
a trust or partnership been established to hold
the insurance and then receive and distribute the
proceeds? If there are more than two or three
shareholders, such an arrangement is normally
more convenient; the alternative is for each
owner to hold a policy on every other owner.         --    --   --

2. If a trust or partnership is not used, is
there a provision ensuring that one of the
owners does not simply keep the insurance
proceeds?                                            --    --   --

B. If the ownership interest will be purchased on
an installment basis:

1. Will a security interest in the stock,
partnership interest, etc., be granted to
the selling owner? If yes, the seller
normally retains the shares until the note is
paid, even though the ownership interest is
transferred on the entity's books.                   --    --   --

2. Does the agreement specify who votes the
ownership interest and receives the benefits of
ownership (dividends, distributions, etc.)
during the installment payment period?               --    --   --

3. If an escrow agent will be used in lieu of a
security agreement:

a. Is the agent a party to the agreement?            --    --   --

b. Is the agent's compensation, if any,
determined by the agreement?                         --    --   --

c. Does the agreement specify whether the
agent will be indemnified and, if so, by whom?       --    --   --

d. Is there a mechanism for unblocking the
logjam if the escrow agent refuses to act?           --    --   --

V. Miscellaneous Provisions

A. Does the agreement or some other document
(such as a corporation's by-laws) require that
the stock certificates or other evidence of
ownership carry restrictive language to make
third parties aware of the existence of a
buy/sell agreement?                                  --    --   --

B. Has applicable state law been reviewed to
determine that the agreement does not violate any
limitations that exist on the right to restrict
transfers of the entity's ownership interest?        --    --   --

C. Should a provision be included to restrict
the issuance of additional ownership interests
by the entity?                                       --    --   --

D. If an S corporation, partnership or limited
liability company (LLC), is there a provision
requiring mandatory cash distributions at least
sufficient to cover the owners' tax liabilities
related to the entity?                               --    --   --

E. If an S corporation, is there a provision
specifying how the entity's income or loss is to
be allocated in the year an owner withdraws? The
income can be allocated based on the "per share,
per day method" or, if all shareholders who hold
stock at anytime during the year agree, based on
the corporation's actual books and records; see
Regs. Secs. 1.1377-1 and 1.1368-1 (g)(2).            --    --   --

F. If an S corporation, is there a provision
protecting the corporation's S election?             --    --   --

G. If a partnership or LLC, is there a provision
specifying how the entity's income or loss is to
be allocated in the year a less-than-50% owner
withdraws (Regs. Sec. 1.706-1 (c)(2)(ii))?           --    --   --

H. If a partnership or LLC, is there a provision
specifying whether the entity must make a Sec.
754 election to step up (or step down) a
transferee partner's share of basis in
partnership property (Regs. Sec. 1.754-1)?           --    --   --

I. Does the agreement provide addresses for
notices and the method for giving notice to the
parties involved?                                    --    --   --

J. Is there a provision that automatically
severs any invalid, illegal or unenforceable
provision from the agreement?                        --    --   --

K. Is there a provision making the agreement
binding not only on the parties involved, but
also their heirs and legal representatives?          --    --   --

L. Have the estate tax implications (i.e.,
pegging a value for the entity) of the agreement
been considered?                                     --    --   --
Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Washington, D.C.