| EXECUTIVE
SUMMARY |
 BUY-SELL AGREEMENTS LET
OWNERS, or shareholders and a
corporation, agree to the terms and
conditions of a future sale to smooth the
transfer of an ownership stake under
certain triggering events. They also
provide a framework for establishing the
purchase price of a business interest
when an owner leaves or dies. CPAs CAN HELP CLIENTS
UNDERSTAND the details of
buy-sell agreements and work with a team
of professionals (such as an attorney, an
insurance agent and an ABV) to ensure an
agreement is correctly prepared.
Misunderstandings over the interpretation
of terms often are at the core of
owners’ disputes about the value of
their respective interest.
TYPICAL BUY-SELL AGREEMENTS
will specify the type of the agreement,
triggers that cause a mandatory or an
optional buyout, a determination of the
appropriate valuation date imposed by the
agreement, the payment terms of the
buy-sell obligation, methods by which the
agreement will be funded, noncompete
agreements between the parties as well as
transfers of an owner’s interests
permitted and prohibited by the
agreement.
ALL TYPES OF CLOSELY HELD
BUSINESSES can use buy-sell
contracts. The two most common types,
cross-purchase and redemption agreements,
typically use insurance to fund the
purchase of ownership interests.
TO DRAFT AN AGREEMENT that
satisfies all owners and precludes future
conflict, the owners need to understand
their goals, the transaction’s
ramifications and their options. Each
party has rights, obligations, tax
considerations and financial
consequences. CPAs can help facilitate
discussion to clarify owners’
choices.
|
| THOMAS F. BURRAGE, CPA/ABV, is
the litigation and valuation services
partner in charge at Meyners & Co.
LLC in Albuquerque, New Mexico. He is
coauthor of Divorce and Domestic
Relations Litigation, recently
published by John Wiley. His e-mail
address is tburrage@meyners.com. CHAD HOEKSTRA, CPA/ABV, is a
member of the Bennett/Thrasher litigation
support and business valuation services
group in Atlanta. His e-mail address is choekstra@btcpa.net. |
usiness owners often ask CPAs about how useful
buy-sell agreements can be for them. The answer
is “very.” A buy-sell contract helps
solve many problems at an unsettled juncture. It
lets business partners, or shareholders and a
corporation, agree to the terms and conditions of
a future sale. That can smooth the transfer of
ownership interest under disruptive circumstances
that may include a partner’s death,
retirement, termination of employment, loss of a
professional license, disability or divorce (or
the transfer of ownership to a spouse),
bankruptcy, insolvency or receipt of a
third-party offer to purchase the business.
Having an agreement gives an owner a ready market
for his or her business interest, resolves estate
liquidity issues, provides a framework for
establishing the purchase price of the interest
and reduces disputes. By ensuring transition
stability, a buy-sell contract also improves
morale among the owner group.
CPAs can help clients
understand the details of these agreements to
better work with legal and other professionals to
draft a buy-sell contract. Where lack of an
agreement or misunderstandings over the
interpretation of its terms are the basis of
owner disputes about the value of their
respective stake in a company, CPAs also help
resolve disagreements and determine whether a
party may be subject to a penalty.
Typical buy-sell agreements
will specify
 The type of agreement.
Triggering events that cause a
mandatory or optional buyout.
A definition of the valuation date
imposed by the agreement.
A baseline purchase price and the
terms of payment.
Methods by which the agreement will
be funded.
Noncompete agreements between the
parties.
Transfers of an owner’s
interests permitted under the agreement.
Transfers prohibited by the
agreement.
Note: It is not
necessary that the same agreement apply to all
owners of an entity.
Do the Math
“Under
a cross-purchase buy-sell agreement,
three owners of a business worth $600,000
would have to purchase $100,000 of life
insurance on one another to fund an equal
purchase of the deceased person’s
share.
Source:
“Insurance for Buy-Sell
Agreements,” Financial and Tax Fraud
Associates Inc., www.quatloos.com.
|
TYPES AND TRIGGERS VARY
Buy-sell agreements apply to all kinds of
organizations including C corporations, S
corporations, limited liability companies, joint
ventures, limited partnerships and general
partnerships. Depending on the nature and
ownership of an entity, types and triggers will
vary, but every effective agreement should
anticipate funding, be kept up to date and
provide for a procedure to determine the purchase
price.
Two common types of buy-sell
agreements—cross-purchase and redemption
agreements—may use insurance to fund the
purchase of ownership interests and are activated
by a partner’s death or disability. A third
type, considered a hybrid of these two, also is
an option.
Cross-purchase
agreement. Upon an owner’s
demise, the remaining owners individually agree
to redeem the business interest of the deceased.
The most common way partners prepare for funding
a purchase in the event of a death is to have
each owner obtain life or disability insurance
policies on the other partners in amounts
sufficient to pay for the business interest.
The advantages of this
type of agreement. The surviving partners
typically receive any life insurance proceeds
tax-free. The proceeds of those life insurance
policies are not includable in the
decedent’s estate. The agreement may or may
not be acceptable to the IRS as defining the fair
market value of the decedent’s business
interest for estate tax purposes. If it is, the
estate or its beneficiaries will have no income
tax on the purchase of the owner’s interest,
as the basis of the interest will be equal to its
sale price. However, IRC section 2703 says an
agreement that undervalues the business interest
for estate-transfer purposes may be invalid.
The disadvantages of a
cross-purchase agreement. Purchasing a life
or disability insurance policy on the life of
each of the other partners becomes increasingly
complex to administer as the number of owners
changes over time. A potentially disparate cost
of life or disability insurance may exist among
owners who are of different ages and health
profiles (young partners may pay very high
premiums to cover older, less healthy owners). If
there’s no insurance, the funding will come
from the aftertax income of the remaining owners.
If a surviving owner must borrow to fund the
buyout, the IRS may classify the interest paid on
the borrowings as investment interest, delaying
the deductibility of the amounts paid.
Redemption
agreement. Under this type of
agreement, the entity typically redeems the
interest of the departing owner. It is
responsible for financing the purchase, which may
be funded by the immediate use of the
business’s resources (such as corporate
savings), a financing arrangement defined by the
agreement, remaining owners’ personal
savings or life or disability insurance on the
life of the departing owner.
The advantages of this
type of agreement. The business is
responsible for its funding. The agreement may
define the fair market value of the
decedent’s interest for estate tax purposes.
If so, the estate or its beneficiaries will have
no income tax on the purchase of the
decedent’s interest, as the basis of the
interest will be equal to its sale price. If the
agreement isn’t fully funded and surviving
owners borrow to fund the buyout, interest
payments to the estate will be deductible on the
entity’s tax return.
The disadvantages of
this type of agreement. If a corporate
entity is the beneficiary of buyout insurance,
the proceeds of the policy may be subject to the
alternative minimum tax. A savings account within
a corporation in anticipation of such an event
may create accumulated earnings tax problems, and
if the business is not a corporation, it may be
difficult to save. In the event a divorce
triggers the agreement, the respective ownership
interest of the remaining owners will change.
Value
There are a number of
ways to value a business interest when
drafting a buy-sell agreement. Common
avenues for establishing the value of an
ownership interest include Fair
market value. “The
price, expressed in terms of cash
equivalents, at which property would
change hands between a hypothetical
willing and able buyer and a hypothetical
willing and able seller, acting at
arm’s length in an open and
unrestricted market, when neither is
under compulsion to buy or sell and when
both have reasonable knowledge of the
relevant facts.” Under a fair market
value standard, a 10% interest in a
company valued at $100 might be worth $5
because of discounts for lack of control
and lack of ready marketability.
Fair value.
Fair value is typically defined by
statute and case law in the state in
which a company is organized and commonly
is interpreted as what is fair or
equitable. In some states this includes
discounts for lack of control or
marketability and in others it does not.
In states in which fair value is not
subject to discounts, it is typically a
pro rata value of 100%. Broadly, 10% of a
company worth $100 would be $10 under
those fair value statutes.
Formula pricing. This
method does not equal fair market value
but is, rather, a means to estimate that
value. Formulas appeal to many parties to
buy-sell agreements because they are
objective and inexpensive to determine.
They may, however, miss subjective
factors that influence fair market value.
Clients using a formula price should
revisit it periodically to make sure
it’s still representative of their
intentions.
Book value. Value is sometimes defined as
net book value as recorded in the
entity’s records, tax returns or as
determined under generally accepted
accounting principles (GAAP). This value
may be based on a company’s
financial statement, audit or tax return.
Net book value is not typically
indicative of fair market value.
Value based on insurance
proceeds. In a buy-sell
agreement, it is not uncommon for the
purchase price of an interest in a
closely held company to be the amount of
an owner’s life or disability
insurance policy proceeds. While this is
a simple method, it may or may not
approximate fair market value. This
variance may cause problems for the
redeemed owner.
Periodic review and
consensus. A company with
several owners may periodically hold
meetings to review and update an agreed
upon value.
|
Hybrid
agreement. Also called the
wait-and-see or combination agreement, this type
of contract is an amalgam of the two categories
above. It usually gives the issuing business the
first right of refusal to buy the ownership
interest and other owners the second option to
buy. This order of consideration is important. If
a C corporation, with accumulated earnings and
profits, assumes a shareholder’s obligation
to purchase another’s stake in a business,
the IRS may impute to the shareholder a
constructive dividend (that is, reclassify it as
a dividend distribution; see “Tax Pitfalls”).
BUILD
A GOOD TEAM
Buy-sell agreements, which formalize the wishes
of two or more owners on an important issue,
often are complex. Each party to the agreement
has rights, obligations, tax considerations and
financial consequences. Depending on the entity,
preparing the contracts may involve a combination
of consultants (to advise clients on succession
issues), business valuators (to determine the
entity’s value), tax professionals (to cite
the relevant tax considerations and maximize
value) and auditors (to deal with the contingent
liabilities created by these off-balance-sheet
agreements). Often a team of professionals from
several disciplines develops the plans, which
then are documented in the agreement.
Tax
Pitfalls
Improperly structured
buy-sell agreements can produce
unintended results. Sometimes
inexperienced practitioners will
recommend drafting a stock-transfer
agreement in a way that subjects either
the buying or the selling party to
unnecessary taxes. Such pitfalls include
but are not limited toIRC
section 302. Some of the
more common errors tax advisers make when
helping create agreements involve
violations of section 302, which applies
to entities taxed as corporations.
Redemption agreements, for example, can
call for a sale of less than 100% of a
shareholder’s interest in a company
(as when an active shareholder wants to
retire but maintain a reduced interest).
However, the section 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 section 302(b)(2)
requirements will not be met if the
shareholder retains an interest in the
voting stock equal to, or in excess of,
80% of the voting stock he or she held
before the redemption (in measuring these
interests, section 318 constructive
ownership rules apply).The 80% rule also
applies to the corporation’s common
stock (voting and nonvoting). On failing
the section 302(b)(2) requirements, the
redeeming shareholder’s limited
interest redemption distribution will be
taxed as dividend income, assuming one of
the other redemption provisions is not
met.
Section 302(b) problems can be 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
deductible funeral and administration
expenses. In such a case, section 303
treats the transaction as a sale or
exchange, regardless of the ownership
percentage retained by heirs or other
related parties. Other requirements also
must be met.
Constructive dividends. Another
common pitfall advisers on buy-sell
agreements must consider involves
cross-purchase agreements. If a
cross-purchase agreement provides that
continuing shareholders have a primary
and unconditional obligation to buy
shares on a triggering event, but the
corporation instead purchases the stock
under a secondary requirement in the
buy-sell agreement, the purchase is
treated as a constructive dividend to the
continuing shareholders. In a properly
structured redemption agreement, the
continuing shareholders are not directly
affected by the acquisition (except for
an increase in their ownership
percentages).
To avoid this problem, tax advisers can
suggest structuring the agreement so that
shareholders have an option to purchase
the stock rather than an unconditional
obligation to do so.
Source:
“Buy-Sell Agreements—An
Invaluable Tool,” a two-part series
in the April and May 2003 issues of The
Tax Adviser.
|
Teams may
include some or all of the following players:
Attorney. Usually
each party to a buy-sell agreement is represented
by an attorney, who ensures an agreement protects
an owner’s interest, correctly represents
his or her wishes and bestows rights and
obligations that are appropriate and enforceable
under local law. If the attorney drafting the
document also is a tax professional, he or she
will make sure the document protects an owner
from adverse tax consequences.
CPA. Buy-sell
agreements create substantial financial benefits
and obligations that affect both buyer and
seller. CPAs understand the impact of those, both
from the business and the individual perspective,
and many are uniquely qualified to address
important income tax considerations for the buyer
and the seller, estate planning for individuals
and the effect of the purchase obligation on the
business.
Insurance agent. Because
life and disability insurance are common methods
of funding based on death or disability triggers,
a competent insurance agent can address this
consideration and be a key member of the team
developing the funding of a buy-sell contract.
Valuator. There
are a number of different methods for determining
price in buy-sell agreements, and a business
valuation professional with the training,
experience and credentials such as the
AICPA’s ABV can provide useful input into
how the parties to the agreement can benefit from
the plan.
THE
AGREEMENT PROCESS
To draft a buy-sell agreement that satisfies all
owners and precludes future conflict, the owners
need to understand their goals, their options and
a future transaction’s ramifications. CPAs
can help clarify owners’ choices and
facilitate discussion. One way to go about it is
to gather all parties to the agreement and their
advisers at a neutral, comfortable site.
| RESOURCES |
| AICPA
Resources |
| Publications AICPA Code
of Professional Conduct, www.aicpa.org/about/code/index.htm.
AICPA
Statement on Standards for
Consulting Services no. 1,
Consulting Services: Definitions
and Standards (paperback: #
005104JA; standalone document: #
055015JA).
Communicating in Litigation
Services: Reports, A
Nonauthoritative
Guide—Consulting Services
Practice Aid 96-3 (# 055000JA).
Conflicts
of Interest in Litigation
Services Engagements—Special
Report 93-2 (# 055141JA).
Engagement
Letters for Litigation
Services—Business Valuation
and Fraud and Litigation Services
Practice Aid 04-1 (# 055298JA).
Litigation
Services and Applicable
Professional
Standards—Special Report
03-1 (# 055297JA).
Conference
2004 Business
Valuation Conference
November 7–9, 2004
JW Marriott Orlando Grande Lakes
Orlando, Florida
For more information, to make
a purchase or to register, go to www.cpa2biz.com
or call the Institute at
888-777-7077.
|
|
Discussion
points the parties must resolve to implement a
buy-sell agreement include but are not limited to
The definition
of value the agreement will use
(see “Value”). The options include using an
objective formula such as multiple of earnings,
multiple of revenue or multiple of book value.
Some practitioners consider formulas objective
(an advantage), but others say they may miss
subjective factors associated with a business (a
disadvantage).
Whether to
employ an independent business valuator. If
yes, the parties must decide how to select the
professionals, how many to use and how to
reconcile differences in valuations. If a
buy-sell agreement directs the use of independent
business valuators, the standard of value that
appraisers use may be fair market value, fair
value, investment value, intrinsic value or book
value. (See “Value”
and the International Glossary of Business
Valuation Terms, www.bvappraisers.org/glossary/glossary.pdf.)
Periodic
agreement of the appropriate value by the owners.
Buy-sell contracts with this
provision will need to be modified at regular
intervals. Resolve how often the contract should
be updated, how those changes will be documented
and what happens if the agreement is not updated.
Owners should ensure that all changes to the
agreement are documented and properly executed.
The option to
let the price and terms of an offer from a third
party establish the price. The
parties can decide to let a third party’s
offer to purchase an interest in the entity set a
price for the business interest.
IRS issues. Clients
may mistake the contractual price set in a
buy-sell agreement as the value for filing Small
Business/Self-Employed Form 706, U.S. Estate
Tax Return, for a deceased owner. If the
value is based on a formula price rather than the
standard of fair market value, the value may not
be acceptable for estate or gift tax purposes. A
buy-sell contract may not impose a binding value
for federal estate tax purposes. If an agreement
fixes the value of a decedent’s interest and
the estate is redeemed for that price, the IRS
can challenge the amount and assess estate tax on
fair market value, which may be higher than the
contractual buy-sell amount. Cases in which this
has happened include Estate of H.A. True, Jr.
and Jean D. True v. Commissioner, TC
Memo 2001-167; Bommer Revocable Trust v.
Commissioner, TC Memo 1997-380; and,
most recently, Estate of George C. Blount v.
Commissioner, TC Memo 2004-116. CPAs may
want to advise clients to include a provision in
the agreement that requires the purchase price on
the death of an owner to be no less than the
value of the shares “as finally determined
for federal estate tax purposes.” (Also see
“Tax
Pitfalls.”)
 |
PRACTICAL
TIPS TO REMEMBER |
|
 To help
facilitate discussion to clarify
owners’ choices, gather all
parties to the agreement and
their advisers at a neutral,
comfortable site. Make sure
the agreement anticipates the
funding requirement of a buyout
and includes a procedure to
determine the purchase price.
Resolve
whether and when the contract
should be updated, how changes to
it will be documented and what
the consequences may be if the
agreement is not updated.
Advise
clients to include a provision in
the agreement that requires the
purchase price on the death of an
owner to be no less than the
value of the shares “as
finally determined for federal
estate tax purposes.”
Make sure
the valuation provisions
don’t provide an incentive
for new shareholders to cause a
triggering event and be bought
out.
Work with
other professionals, such as a
lawyer, an insurance agent and an
ABV, who are experienced in
advising clients regarding the
drafting of buy-sell agreements.
|
|
Penalty
for leaving early/misconduct/involuntary
misconduct. To dissuade shareholder
employees from leaving the company, some buy-sell
contracts give individuals who leave voluntarily
or for misconduct as defined by the agreement
less than they would otherwise receive. If an
owner’s employment is terminated for cause,
a “penalty price” such as net book
value, some percentage of fair market value or a
defined value may be applied.
A
shareholder’s divorce. Many
entities want to protect the business against an
owner’s spouse obtaining an interest. If so,
include language in the agreement to require
purchase of a spouse’s ownership interest
should he/she end up with stock in a divorce
settlement. In any event, it is common to require
the business owner’s spouse to become a
party to the agreement. Spouses should have
independent legal counsel. Note: If this
provision is invoked, the divorcing owner’s
interest in the business will be diluted.
New
shareholders. New stakeholders may
be required to be a party to existing buy-sell
agreements before becoming shareholders. Make
sure the valuation provisions don’t provide
an incentive for them to cause a triggering event
and be bought out (see “Warning:
Don’t Give Shareholders an Incentive to Sell”).
BOTTOM
LINE
Buy-sell agreements can be a valuable tool for
closely held businesses and owners who want to
protect their ownership interests. But if drafted
improperly, these contracts can cause problems
for both buying and selling parties. To ensure a
satisfactory outcome, owners should work closely
with their CPAs and a team of professionals such
as an attorney, an insurance agent and an ABV to
prepare an appropriate buy-sell agreement.
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