A buy/sell agreement is a contract that restricts business owners from freely transferring their ownership interests in the business. Such agreements are a tool in providing for a planned and orderly transfer of a business interest. Some of the more important advantages of a buy/sell agreement are to:
- Provide for business continuity upon the death, disability, or retirement of one of the shareholders;
- Establish a market for the corporation’s stock that might otherwise be difficult to sell;
- Ensure that the ownership of the business remains with individuals selected by the owners or remains closely held;
- Provide liquidity to the estate of a deceased shareholder to pay estate taxes and costs; and
- Support the family of a deceased shareholder with the proceeds of the sale.
One of the disadvantages to a buy/sell agreement is that the cash paid for premium payments on life insurance that fund the buy/sell agreement is not available for business operations and shareholders’ personal expenses. Also, circumstances may change after the buy/sell agreement is adopted that cause purchasers to regret the obligation to buy a withdrawing owner’s interests.
In the context of a closely held corporation, a buy/sell agreement is a contract between the shareholders or between the shareholders and the corporation. The contract provides that a shareholder’s stock will be sold (or at least offered for sale) to the other shareholders or to the corporation upon the occurrence of a specified event. Such events usually include death, disability, and retirement, but may also include such circumstances as divorce, bankruptcy, or inability to practice one’s profession. The agreements may also be designed as a right of first refusal in the event one or more of the shareholders wish to sell their stock.
In a redemption agreement, the shareholder and the corporation enter into a contract in which the shareholder agrees to sell his or her shares to the corporation according to the price, terms, and circumstances specified in the contract. Redemption agreements typically grant the corporation the right of first refusal if there is an offer from a third party to purchase the interest.
Many closely held corporations have stock buy/sell agreements for valuing and purchasing the shares of a deceased or disabled shareholder or a shareholder whose employment with the corporation is terminating. When more than two shareholders are involved, and particularly when life or disability insurance is used to fund the agreement, these buyouts are often structured as stock redemptions (paid for with corporate dollars) rather than stock cross-purchase transactions between the shareholders.
A stock redemption buy/sell agreement is a contractual arrangement between the shareholders and the corporation in which the corporation is obligated to redeem the shares of a deceased or disabled shareholder. Upon the death or disability of a shareholder, that shareholder’s stock must be returned to the corporation for payment according to the terms established in the buy/sell agreement. If the stock redemption agreement is funded with life insurance or disability insurance, the corporation pays the premiums. Also, the corporation owns the insurance policy and is the policy’s beneficiary.
The costs of the insurance premiums are carried proportionately by all shareholders because the corporation is responsible for all premium payments. A younger shareholder or a shareholder owning fewer shares is not required to pay larger insurance premiums to cover other older shareholders or other shareholders who own more shares. The administration of the arrangement is simplified because there is only one life insurance policy on each shareholder, and the legal agreement can be drafted as a single document. Conversely, under a stock cross-purchase agreement, each shareholder must carry a life insurance policy on all the other shareholders.
However, the remaining stockholders do not receive an increase in their tax bases in the corporate stock. This contrasts with a stock cross-purchase buyout arrangement under which the remaining stockholders acquire the shares individually and receive a corresponding increase in their tax bases. Furthermore, stock redemption payments that are treated as nonliquidating corporate distributions may result in a taxable dividend for the recipient if the transaction fails to qualify as a stock sale under one of the Sec. 302 or 303 exceptions.
Observation: The tax results for a shareholder with little or no stock basis may be essentially identical whether the redemption is treated as a taxable dividend or as stock sale proceeds because the federal income tax rates on qualified dividends and long-term capital gains are the same for 2011 and 2012. But if the shareholder has significant capital losses from other transactions, sale treatment is preferred, because those capital losses can be used to offset the capital gain triggered by the redemption transaction.
Redemptions have complex tax implications and a high potential for adverse income tax consequences:
- If the corporation pays more than the stock’s fair market value (FMV), the selling shareholder may have received a gift from the remaining shareholders or compensation from the corporation.
- If the corporation pays less than the stock’s FMV, the remaining shareholders may have received either a gift or compensation (Rev. Rul. 58-614).
- To qualify for sale or exchange treatment, the redemption must meet the applicable requirements. For example, if the redemption agreement calls for a sale of less than 100% of the shareholder’s interest, the complete termination or substantially disproportionate requirements of Sec. 302(b) may not be met, causing the distribution to the shareholder to be taxed as a dividend. However, with the 2011 and 2012 preferential tax rates on qualified dividends, this outcome may not be as harmful as it used to be.
- If the corporation is the beneficiary of a life or disability insurance policy funding the stock redemption, the insurance proceeds could trigger the corporate alternative minimum tax because the insurance proceeds would be included in the accumulated current earnings (ACE) adjustment (Regs. Sec. 1.56(g)-1(c)).
Example 1: DKW Corporation has 1,000 shares of stock issued and outstanding. D owns 800 shares. K and W each own 100 shares. D wants to retire and maintain a reduced interest in DKW . DKW redeems 600 of D ’s shares. After the redemption, DKW has 400 shares issued and outstanding. D owns 200 of those shares, resulting in a 50% ownership interest. The redemption does not qualify for sale or exchange treatment under Sec. 302 and will be treated as a distribution of property under Sec. 301. D should restructure the transaction to qualify for capital gain treatment under Sec. 302.
A cross-purchase agreement is a contract between the shareholders of the corporation to offer their shares for sale to the other shareholders at the price and terms specified in the agreement. In the event of a shareholder’s death, the estate is normally required to offer the decedent’s ownership interest to the other shareholders at the specified price and terms. If there is no third-party buyer, the other shareholders are generally obligated to buy the interest in the event of specified circumstances (such as death, disability, or retirement). These agreements normally are funded with insurance and therefore function best when the corporation has only two or three shareholders. As the number of shareholders increases, the cost of creating a workable arrangement can become too high due to the larger number of insurance policies required.
Cross-purchase arrangements avoid the risk of dividend treatment for shareholder buyout payments. However, if the corporation purchases the stock (even though the remaining shareholders were obligated to do so) because of a secondary agreement under the buy/sell agreement, the purchase could be treated as a constructive dividend to the remaining shareholders. To avoid constructive dividend treatment, the buy/sell agreement should be structured so that the remaining shareholders have an option, rather than an obligation, to purchase the departing shareholder’s stock. Also, when the change in stock ownership qualifies as an ownership change under Secs. 382–384, a corporation’s ability to use certain tax attributes, such as NOLs and capital loss carryovers, may be drastically reduced.
Example 2: J and his two brothers, G and F , formed H , Inc. 10 years ago. For the first eight years, the three brothers were equal shareholders, but within the past two years, the stock has been distributed (by gift and sale) to one son of J , two daughters of G , and three sons of F . All of the current shareholders are in good health.
When the brothers founded the company, they signed a shareholder agreement that gave the company an option to redeem the shares at a price to be annually agreed upon by the shareholders. Since the existing agreement does not include the children of the three founders, a new agreement should be prepared and signed by all existing shareholders. (Future shareholders should be required to sign the agreement as a condition for making a valid transfer to them of the stock.) J says that his estate will be split among his spouse, children, and any grandchildren and adds that his two brothers have similar wills.
Sale or exchange treatment upon the redemption of stock from J ’s estate is unlikely. Sale or exchange treatment generally requires that the estate completely terminate its interest in the company. However, the estate cannot completely terminate its interest in the company since estates cannot waive family attribution when a beneficiary of the estate owns stock in the company in his or her own name (Secs. 302(b)(3) and (c)). The redemption of the estate’s stock could have occurred when the three brothers were the only shareholders because the family attribution rules do not apply to siblings.
Alternatively, the sale of stock from J ’s estate results in sale or exchange treatment if the shareholders use a cross-purchase agreement. In a cross-purchase agreement, one or more of the remaining shareholders agrees to purchase the stock from the estate of a deceased shareholder or from the departing shareholder. The acquiring shareholders obtain a basis in the purchased shares equal to the acquisition price and obtain a new holding period for the stock.
Hybrid agreements typically are used when there is no insurance to fund the purchase of ownership, such as when an owner is uninsurable. A hybrid agreement provides the shareholders with flexibility to decide who will make the stock purchase when a triggering event occurs. Some hybrid agreements provide that the shares will be offered first to the corporation and then to the other shareholders if the corporation does not buy the shares. In other agreements, the shareholders may have the first option to purchase the shares with the corporation required to redeem the shares if the shareholders decline to make the purchase. Or part of the shares may be offered first to the corporation and the remainder to the other shareholders.
Hybrid agreements should be drafted carefully to avoid a situation where the remaining shareholders are obligated to purchase a withdrawing shareholder’s stock, but the corporation actually ends up making the purchase. (This might occur when the shareholders and corporation are both obligated under a mandatory purchase obligation.) If a corporation discharges an obligation of a shareholder, the shareholder can be treated as receiving a constructive dividend up to the amount discharged. Giving the remaining shareholders a right of first refusal, with the corporation obligated to purchase the stock if the shareholders do not exercise the right, may avoid this problem.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 24th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Mary C. Danylak, Timothy Fontenot, James A. Keller, Brian B. Martin, and Robert Popovich, published by Thomson Tax & Accounting, Ft. Worth, TX, 2011 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.