Using a Buy/Sell Agreement to Restrict Transfers of Partnership Interests

Editor: Albert B. Ellentuck, Esq.

A buy/sell agreement is a popular way to establish some parameters for the disposition of a partnership interest while establishing a method that can be used to value the interest and the terms of a potential payout. A buy/sell agreement is a contract among the partners of a partnership that generally provides for the sale of a partner’s interest to the other partners or the partnership upon the occurrence of a specified event-usually the death, disability, or retirement of the partner.

Buy/sell agreements for partnerships can be redemption (liquidation) arrangements, cross-purchase arrangements, or a hybrid of the two. A partnership liquidation buy/sell agreement requires the entity rather than the other owners to purchase the interest of an owner at a stated price and under designated terms in the event of the owner’s death or certain other circumstances. The same basic considerations apply to a sale of a partnership interest under a cross-purchase agreement as to any other sale of such an interest. In general, the gain or loss on the sale of the interest is capital in nature (Sec. 741).

Buy/sell agreements can restrict transfers of a partner’s interest by:

1. Requiring the selling partner to obtain the other partners’ consent before transferring the partnership interest. Consent restrictions are generally upheld if the consent is not unreasonably withheld and refusals are based on legitimate business reasons.
2. Granting the remaining partners (or the entity) a right of first refusal. Rights of first refusal are commonly used and are generally held to be enforceable. A right of first refusal usually allows the remaining partners to purchase the interest at the price offered by the third party, the price stated in the buy/sell agreement, or the lower of the two.
3. Specifying (in some manner) the allowable transferees. Although this can ensure that the partner’s children will succeed to his or her interest, the partner’s estate may be left with inadequate assets to pay expenses since there is no market for the partnership interest. In addition, this method will not establish an estate tax value for the deceased partner’s interest.

Restricting Transfers at Death

Another common provision restricts transfers at death. Business partners use these provisions to eliminate the risk that a partner’s heirs will disrupt business operations. This is usually accomplished by requiring the mandatory purchase (by the surviving partners and/or the entity) of a deceased partner’s interest. Mandatory purchase options create a ready and dependable market (because the purchase is a contractual obligation) for a decedent’s partnership interest and provide a source of liquidity. Alternatively, the surviving partners may be granted an option to acquire the deceased partner’s interest.

Business partners are often wary of mandatory purchase provisions because the ability to pass their business interest to their children will terminate if they die prematurely. If the purchase price is unfairly high (e.g., the formula was inappropriate or the appraisal is ­incorrect), the children may be legally obligated to purchase a business interest for much more than it is really worth. This reluctance may be more prevalent if the partner’s children work in the business and are intended successors. In these instances, the partner must weigh the benefits of the agreement (liquidity, fixed estate value, and limits on outside partners) against the risk of premature death and the termination of family ownership.

Generally, partners of closely held businesses consist of family members or business associates who have demonstrated an ability to work together. To preserve the harmonious relationship, partners often implement measures designed to minimize the risk that an outsider will obtain a partnership interest. For example, a right of first refusal restricts a partner’s ability to sell his or her interest, giving the remaining partners the option to purchase the selling partner’s interest before it can be sold to an outside party. The price and payment terms available to the remaining partners under the right of first refusal should be specified in the buy/sell agreement.

Restricting Transfers Upon Divorce

One of the most common and potentially disruptive partnership transfers occurs when a business partner divorces. In family businesses, the problem may extend to the spouses of children who are active in the business. This problem may be more pervasive in community property states, where each spouse is considered to own half of all community property. Under any fact pattern, a potentially disruptive situation can occur if the other partners are forced to deal with a disgruntled spouse.

The disruption caused by the transfer of a divorcing partner’s interest can be minimized by granting the divorcing partner a right of first refusal to acquire any transferred interest. This allows the divorcing partner to maintain his or her present ownership percentage in the business. The price paid for the interest would be fixed in the buy/sell agreement. If the divorcing partner does not choose to acquire the transferred interest, the spouse is free to keep it or sell it to an outsider (unless the buy/sell agreement provides the other partners with a right of first refusal).

A mandatory buyout in the event of a partner’s divorce would obligate the partners or the entity to purchase a spouse’s interest. This provision may be beneficial in family business situations where a son-in-law or daughter-in-law has acquired shares.

Addressing Language to Include in a Buy/Sell Agreement

If the partners decide to enter into a buy/sell agreement, they should consider including in the agreement a requirement to prorate the amounts of the partnership’s items of income, gain, deduction, loss, and credit based on time before and after the disposition of the interest in the event a partner’s entire interest is disposed of during a year. This method is an alternative to the default method that requires an interim closing of the books (Regs. Sec. 1.706-1(c)(2)(ii)).

The owners of a majority interest in a partnership or LLC may be able to force minority owners to sell their interests by withholding partnership distributions sufficient to pay the partner-level taxes on passed-through partnership taxable income and gains. This potential tyranny of the majority problem can be avoided by requiring in the buy/sell agreement or the partnership agreement that the entity distribute to all owners an agreed-upon percentage of passed-through net income and gains. Note that this requirement may be inappropriate if there are special allocations of income and loss amounts. However, such a requirement generally makes sense when all tax items are allocated pro rata among the owners.

The partners may want to include language about making a Sec. 754 election. However, if the partnership’s property might drop in value, they should avoid making such an election mandatory. The owners may also want to include in the buy/sell agreement language restricting cross-purchase transactions that result in a technical termination of the entity (under Sec. 708(b)(1)(B)).

Valuing the Partnership Interest

Partnership agreements and state law generally permit partners to determine who their partners will be. Restricting partners from freely transferring their interests can result in valuation adjustments for lack of marketability. Generally, the partnership’s liquidation value is an inappropriate base for valuing a transferred partnership interest when the transferee is precluded from selling, gifting, or otherwise liquidating an interest by the terms of the partnership agreement. Precluding a transferee from taking such actions could result in the transferee’s acquiring only an assignee interest, which would entitle him or her generally only to the transferor partner’s share of partnership distributions. As a result, a hypothetical willing buyer of an assignee interest would generally pay no more than the present value of future partnership distributions for the interest, which will often be significantly less than the liquidation value.

Under the Revised Uniform Limited Partnership Act, a limited partner can withdraw from the partnership and receive fair value for his or her interest upon six months’ notice, unless otherwise provided in the partnership agreement. However, the partnership agreement might provide a definite time such as 15 years or a specified event upon which a limited partner can withdraw. Absent such a provision in the partnership agreement, the limited partners can withdraw at will and receive fair value; this makes the limited partner’s interest more liquid, thus increasing its fair market value. Under the newer Uniform Limited Partnership Act (2001) (currently adopted by 18 states and the District of Columbia), a limited partner “does not have a right to dissociate as a limited partner before the termination of the limited partnership” (ULPA (2001), §601(a)), and while a limited partner can be allowed to dissociate from the limited partnership on the occurrence of certain events, any power to dissociate can be eliminated by the partnership agreement (ULPA (2001), §601(b)).

Limited partners may be given the right to vote on certain matters such as fundamental changes in the structure or business of the partnership. Thus, they may be of equal power with general partners in regard to such matters, even though they have no say over other matters (e.g., distributions). The presence of limited partner voting rights and management duties may cause a reduction in the amount of any minority discount an appraiser using an asset-based valuation method will allow.

Finally, if distributions to limited partners can be made only at the discretion of the general partner (with no minimum distribution requirement), the value of the limited partners’ interests will be reduced accordingly. However, before granting absolute control over distributions to the general partner in order to maximize valuation discounts, the risk that the IRS could disregard the partnership entirely for income tax purposes under Sec. 704(e) should be considered.

This case study has been adapted from PPC’s Tax Planning Guide-Partnerships, 28th Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Cynthia Zatopek, and James A. Keller, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).