Protecting Yourself and Your Business With A Buy-Sell Agreement
Regardless of whether a business is operated as a corporation, a limited liability company (“LLC”) or a partnership, a Buy-Sell Agreement can help protect the owners and the business.
A Buy-Sell Agreement is a type of contract that generally restricts the owners from freely transferring their stock or interests to outsiders. In addition, a Buy-Sell Agreement may provide for optional purchase rights or mandatory purchase obligations by the owners or the entity upon certain trigger events, such as an owner’s death, divorce, bankruptcy, disability, incapacity, retirement or termination of employment.
This article will summarize (1) the primary reasons for a Buy-Sell Agreement, (2) common provisions in a Buy-Sell Agreement, and (3) certain federal income tax considerations related to a Buy-Sell Agreement.
Primary Reasons for a Buy-Sell Agreement The primary reasons to implement a Buy-Sell Agreement include the following:
- to restrain the owners from freely transferring their stock or interests to outsiders,
- to protect and preserve the business from internal fights among the owners,
- to provide a market for a deceased owner’s stock or interests at death, to grant purchase rights in the event an employee is terminated from employment, and to restrict the employee from competing with the business,
- to provide purchase rights upon certain other trigger events, such as an owner’s incapacity, disability, retirement, divorce or bankruptcy to help the business continue operating with active owners and without the interference of an owner’s creditors or spouse, and
- to help establish a business succession plan with certain persons to receive (or have the right to purchase) stock or interests after the death of certain owners.
Common Provisions in a Buy-Sell Agreement
The owners of a business should consider these provisions when designing their unique Buy-Sell Agreement (“Agreement”):
Permitted Transferees: The owners may agree to allow transfers of stock or interests to certain persons (“Permitted Transferees”) without the consent of the other owners, such as an owner’s children, an owner’s revocable trust (for estate planning purposes) or the other owners.
Right of First Refusal: An Agreement may provide that, if an owner wants to transfer his or her stock or interests to a non-Permitted Transferee, the owner must first offer to sell his or her stock or interests to the other owners (i.e., a cross-purchase) and/or the entity (i.e., a redemption).
Optional or Mandatory Trigger Events: Some common events that may trigger optional purchase rights or mandatory purchase obligations under the Agreement include an owner’s death, disability, incapacity, bankruptcy, divorce, retirement or termination of employment (“Trigger Events”).
Employee Owners: The owners may want the right to purchase the stock or interests of an employee owner who is terminated from employment for cause or for any reason. The Agreement may also provide for the forfeiture of an employee’s stock or interests in certain events.
Drag-Along Rights: To help avoid disputes with minority owners, the Agreement may allow the majority owners to force the minority owners to sell their stock or interests to a third party on the same terms as the majority owners (a “drag-along right”).
Tag-Along Rights: A minority owner may want the right to sell his or her stock or interests to a third party on the same terms as the majority owners (a “tag-along right”).
Shoot Out: To help resolve a major dispute between owners who can no longer work together, the Agreement may contain a “shoot out” provision in which any owner (the “Offeror”) may approach another owner with a set price per share of stock or interest, and the other owner then elects whether to buy-out the Offeror or to sell his or her stock or interests to the Offeror at the set price per share of stock or interest. Thereafter, either the Offeror or the other owner will be out of the business.
Simultaneous Death: In the event of a simultaneous death of all of the owners, the terms of the Agreement may provide that all of the purchase rights and obligations terminate or that certain purchase obligations must be undertaken by the estates, trusts or heirs of the deceased owners.
Non-Competition, Non-Solicitation and Confidentiality: If an owner is bought out of a business, the Agreement may state that the owner may not compete with the business, solicit the employees, customers or clients of the business, nor disclose any confidential information, trade secrets, customer lists or other records of the business.
Tax Distributions: Owners of a pass-through entity, such as an S corporation, LLC or partnership (especially minority owners) may want the Agreement to mandate the distribution of a certain amount of cash to the owners each year to help the owners pay their respective income taxes on their allocated share of the entity’s net profits.
Purchase Price: The Agreement should set forth the manner of determining the purchase price for an owner’s stock or interests upon the Trigger Events. The purchase price is often based on fair market value, a formula related to book value or as a multiple of business earnings. Such value may be determined by an annual agreement of the owners, the agreement of the selling owner and the purchasing owner, a certified public accountant, or an appraisal process. The Agreement should address whether discounts, premiums and/or goodwill relative to the stock or interests should be taken into account.
Payment Terms: The Agreement should state the payment terms for the purchase of the selling owner’s interest or stock. If life insurance is funding the purchase, the selling owner is often paid in cash at closing. Alternatively, the Agreement may allow the purchaser to pay a certain percentage of the purchase price in cash at closing and deliver a promissory note for the balance. A promissory note may provide for a long payout at a favorable interest rate or a short payout at a commercial interest rate (or any combination of such terms).
Resolution of Disputes: As an alternative to court, the Agreement may require arbitration or mediation to help resolve disputes among the owners.
Binding Successors and Spouse: The Agreement may require the owners to include provisions in their respective Wills and Trusts to help bind the owners’ representatives and trustees to carry out the terms of the Agreement. The owners may require spouses to sign the Agreement to help enforce any purchase rights in the event of a divorce.
Certain Federal Income Tax Considerations
Following is a general summary of certain federal income tax considerations related to redemptions and cross-purchases. To avoid unanticipated tax consequences, an owner should consult with a member of McGrath North’s Tax Group before engaging in any such transaction. The federal income tax consequences related to redemptions and cross-purchases are complex and vary depending on the type of entity. In addition, there are exceptions and detailed requirements to many of the general rules summarized herein.
C Corporation Redemption: If a C corporation has earnings and profits, a redemption should be closely analyzed to make sure the amount received by the selling shareholder will not result in an unintended dividend to such shareholder. If the redemption is treated as a dividend, the selling shareholder will have ordinary income for the full amount received (without reduction for the shareholder’s basis in his or her stock) to the extent of the shareholder’s share of the corporation’s earnings and profits. For the excess of the amount received by the selling shareholder over the deemed dividend, if any, the shareholder’s basis in his or her stock will be reduced dollar for dollar (but not below zero) as a tax-free return of basis, and the balance of the amount received by the selling shareholder, if any, should be capital gain (long-term if the stock was held over one year, otherwise short-term).
To help ensure a redemption is classified as a sale (and not a dividend), a selling shareholder may want the redemption structured as (1) a redemption resulting in a complete termination of the shareholder’s stock in the corporation (with a waiver of any family attribution rules for a family corporation), or (2) a redemption that results in a meaningful reduction of the shareholder’s ownership of stock in the corporation. As a sale, the selling shareholder will recognize capital gain (long-term if the stock was held over one year, otherwise short-term) to the extent the amount received exceeds the shareholder’s tax basis in his or her stock. The C corporation should not generally recognize gain or loss unless it uses appreciated property to fund the redemption. The tax basis of the remaining shareholders’ stock will not be increased with a corporate redemption.
Cross-Purchase by C Corporation Shareholders: If another shareholder purchases the selling shareholder’s stock, the purchasing shareholder should receive a tax basis in the purchased stock equal to the purchase price. The selling shareholder will recognize capital gain (long-term if the stock was held over one year, otherwise short-term) to the extent the amount received exceeds the selling shareholder’s tax basis in his or her stock.
S Corporation Redemption: If an S corporation (that was not previously a C corporation) redeems a shareholder’s stock, the amount received by the selling shareholder will first reduce the shareholder’s tax basis in his or her stock dollar for dollar (but not below zero) as a tax-free return of basis, and the balance of the amount received, if any, should be capital gain (long-term if the stock was held over one year, otherwise short-term). If an S corporation funds the redemption with life insurance proceeds, each shareholder should receive a proportionate increase in his or her stock basis equal to his or her share of the life insurance proceeds received by the corporation (but not generally the full basis step-up available with a cross-purchase). If the S corporation redeems a shareholder’s stock with appreciated property, the redemption will result in gain to the shareholders to the extent of the appreciation in the distributed property.
Cross-Purchase by S Corporation Shareholders: With a cross-purchase by another shareholder, the selling shareholder will recognize capital gain (long-term if the stock was held over one year, otherwise short-term) to the extent the amount received exceeds the shareholder’s tax basis of his or her stock. The purchasing shareholder should receive a basis in the purchased stock equal to the purchase price.
Partnership/LLC Redemption: In general, if the entity redeems an owner’s interest, the owner should only recognize gain if the amount of cash (and marketable securities) distributed to the owner (plus any debt relief) exceeds the owner’s tax basis in his or her interest. If the owner receives other property, the owner should not generally recognize gain unless the owner’s debt relief exceeds the owner’s tax basis in his or her interest. Any gain is generally capital gain (long-term if the interest was held over one year, otherwise short-term) except that part representing the owner’s share of any substantially appreciated inventory or unrealized receivables.
Cross Purchase by Owners of Partnership or LLC: If another owner purchases the selling owner’s interest, the purchasing owner should receive a tax basis in the purchased interest equal to the purchase price. The selling owner will recognize capital gain (long-term if the interest was held over one year, otherwise short-term) to the extent the amount received (including debt reduction) exceeds the selling owner’s tax basis in his or her interest, except for the part relating to the selling owner’s share of any substantially appreciated inventory or unrealized receivables. If a 754 election is made upon a transfer of interests during an owner’s life or at death, the recipient of the interest may also get a step-up in basis of the entity’s assets relative to the transferred interest.
An owner’s tax basis in his or her stock or interests is computed differently for each entity. If an individual receives a gift of stock or interests, his or her basis in the gifted stock or interests is often equal to the transferring owner’s basis (i.e., a carry-over basis). If an individual receives stock or interests on a deceased owner’s death, his or her basis in the inherited stock or interests should be equal to the fair market value of the stock or interests at the time of the deceased owner’s death (i.e., a stepped-up basis). Before entering into any redemption or cross-purchase, a business owner should consult with a member of McGrath North’s Tax Group to determine the owner’s tax basis, the amount received (or realized) and any anticipated gain or loss.
