Business Succession Planning using Buy/Sell AgreementsBecause the one thing you can usually count on is change By James B. Wright, Esq. |
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If a closely held company is to grow and endure, changes in ownership are inevitable.
Obviously, such changes are best provided for in advance. Business succession planning,
including both ownership succession and management succession, is best considered not only
by older business owners approaching retirement, but by younger owners too. A typical
40-year old small business owner, for example, has a much higher percentage of his or her
net worth tied up in the business than the typical owner on the eve of retirement. The
financial impact of the failure to plan, therefore, may be much greater to the younger
owner and his or her family than to those of the older owner. For contractors especially,
succession planning is even important to the current operation of the business. Many
bonding companies, as well as commercial lenders, require that written plans of business
continuity and succession be in effect prior to extending credit. Buy/Sell Agreement A Buy/Sell Agreement is often an integral part of such planning. It is an agreement between the owners of a closely held company providing for an orderly transition in certain events. It places restrictions on the ability to transfer interests in the company to outsiders, and requires the sale of an owner’s interest to the company or the other owners upon the departure, disability, retirement or death of an owner. Without formally addressing these events in advance, any one of them can cause the demise of the company through a forced sale of assets, often at rock bottom prices. A Buy/Sell Agreement also provides for the determination of the purchase price for such interest and the terms for payment thereof when these events occur. These things are best determined in advance, when all of the owners have common interests and none knows whether he or she will be buying or selling an interest upon a triggering event in the future. After such an event occurs, the owners have differing interests, making it more difficult to agree upon value and terms for payment, increasing the likelihood of the matter being determined in court after a costly battle of appraisers. For example, one of several owners of a company is in an automobile accident, rendering him incapable of working at all for months, and then only in a reduced capacity thereafter. Or, a disgruntled owner sells his interest in the company to a stranger, who shows up at work and announces that he is your new partner. Worse yet, an owner gets divorced, and his or her former spouse demands to vote a one-half, community property interest in the divorced owner’s stock at the next stockholders meeting. More common, one of several owners dies. His personal representative wants to sell the deceased owner’s stock, but the company lacks funds to purchase it. These and other issues are addressed in a properly drawn Buy/Sell Agreement. Three basic types of Buy/Sell Agreements There are three basic types of Buy/Sell Agreements:  First, stock redemption agreements where the company agrees to purchase the
departing owner’s interest,
The stock redemption agreement has the advantage of simplicity. One entity, the company, purchases the departing owner’s interest. Funding the agreement is more manageable and easier to control if done by the company, especially if there are more than two participants. The corporation can own the insurance on the lives of each owner, obviating the need for multiple policies on each owner or the need for a like insurance trust. Income tax considerations Income tax considerations, however, may make the cross purchase arrangement more desirable. The remaining owners purchasing a deceased shareholder’s shares received a stepped-up basis in the acquired stock equal to the value of the purchase price of the deceased shareholder’s stock. The departing shareholder receives capital gains treatment rather than a potential dividend (ordinary income) on the sale of the stock. If the arrangement is funded by life insurance, however, the owners may need a life insurance trust to avoid each owner having a life insurance policy on the life of each other owner. Since neither the company nor the individual owners can deduct the life insurance premiums use to fund buy-out agreements, a stock redemption agreement where the corporation pays the premiums is advantageous if the corporation is in a lower tax bracket than the shareholders. Conversely, if the shareholders are in lower tax brackets than the corporation, a cross purchase agreement with the shareholders paying the premiums may be preferable. This particular consideration, however, is not present in an S Corporation or LLC, which is not a separate tax paying entity. The lesson is that your CPA or tax advisor should be consulted in structuring the buy/sell agreement. A hybrid agreement either mixes and matches or makes redemption or cross-purchase the secondary method if the interests are not all purchased under the first method. This can be advantageous and create an opportunity for choosing which method is best after the transfer event has occurred. Establishing the value of the departing owner’s interest Perhaps the most problematical of issues surrounding the buy/sell agreement is choosing the method of establishing the value of the departing owner’s interest in the company. There are many methods of determining value, and each has limitations. A few of the common methods include determining value with reference to book value, capitalizing the earning of the company over a fixed period of time, setting the value by independent appraisal, or periodically setting a fixed value by mutual agreement of the owners of the company. Experience shows that having the owners periodically determine the value is seldom satisfactory; they seldom get around to doing it and the value gets stale. A backup, such as determining the value by appraisal is the owners haven’t set the value in the last year or two, is a wise addition to the agreement. Three ways to fund a buyout The three ways to fund a buyout are: a cash sale, which requires savings; a financed sale whereby part of the sales price is represented by a promissory note usually secured by a pledge of the stock being transferred; or a sale funded by life insurance. Payment terms must be realistic and care must be taken to avoid sale terms that will harm the company. There are also state law restrictions on when a corporation can repurchase its own stock. Insurance necessary component Often, therefore, insurance will be a necessary component of the buy/sell arrangement. Your agent will be more than happy to describe the myriad of available insurance plans for this purpose. Generally, the premiums on policies purchased to fund a buyout are not deductible. Using insurance in a cross-purchase situation where there are more than a few owners can get complicated. The problem is that each owner needs a policy on each other owner. This complication can be handled, however, through an escrow agent or trustee who holds one policy on each owner, with each owner contributing to the payment of premiums on the policies on other owners. If you have a Buy/Sell Agreement, review it! If not, consider one! If you have a Buy/Sell Agreement now, review it! Be sure that the valuation is up to date and that the valuation formula fairly determines the value of the company's stock. Be sure you have an adequate funding mechanism so that money is available for a buyout when necessary. If you don't have an agreement, it's time to consider one with your legal and tax advisors. ___________________________________________________________ © Folk & Associates, P.C. All rights reserved to reproduction in any format or medium. |
Third, hybrid agreements that combine elements of the other
two.