Buy/sell agreements for S corporations

Buy/sell agreements are widely used among S corporation shareholders (i.e., cross–purchase agreements) or between an S corporation and its shareholders (i.e., redemption agreements). Such agreements meet a multitude of general business as well as succession planning objectives. Because of the rules unique to S corporations, a number of issues should be considered when drafting a buy/sell agreement. Among the unique S corporation tax issues are:

• Preserving S status;
• Limiting the number of shareholders and preventing transfers to ineligible shareholders;
• Avoiding problems with the one-class-of-stock restriction;
• Allocating income and loss items as they relate to a terminating shareholder’s interest, as well as termination of S status; and
• Providing for the amount and timing of operating distributions.

Preserving S status

Preventing transfers to ineligible shareholders

A buy/sell agreement can be used to restrict the type and number of persons who can be shareholders and to restrict ownership to those persons who are eligible shareholders (see Sec. 1361(b)(1)(B)). S corporation buy/sell agreements should include language prohibiting shareholders and the corporation from the following:

• Transferring or issuing shares to a corporation (other than certain tax-exempt corporations), partnership, ineligible trust, or nonresident alien individual;
• Transferring or issuing shares to a new shareholder, if the result would violate the 100-shareholder rule; and
• Giving up U.S. citizenship (or U.S. residency).

To avoid claims of ignorance of the transfer restrictions, the stock certificates should bear legends referring to the buy/sell agreement and to specific provisions restricting transfer rights.

Requiring notification

The buy/sell agreement should include a requirement that a shareholder notify the corporation when a prospective transfer is contemplated. In addition, a transfer agent should be appointed to verify that a prospective transfer does not violate the S election. Notice requirements enable the owners to review a proposed transaction to ensure that it will not terminate the corporation’s S status.

Voiding prohibited transactions

If permitted under local law, the agreement could provide that prohibited transfers are void immediately. This way the transfer will not have any force or effect under local law and arguably should not terminate S status. If prohibited transactions are only voidable, S status may not be preserved.

Indemnification

Shareholders should also consider using an indemnification clause to protect the remaining shareholders from the loss of S status following a prohibited transfer. The measure of such damages should reflect several factors including (1) the likely monetary damage of a termination of S status to the other shareholders; (2) any restrictions on reelecting S status; and (3) mitigating factors, such as an IRS waiver of an unintended termination under Sec. 1362(f).

The buy/sell agreement should provide for the right to enforce the agreement in equity, thereby enabling the corporation to void, as determined under local law, a prohibited transfer — as opposed to merely seeking an award for damages.

Corporate-level restrictions

The agreement could require that any adjustment to either capital or debt be structured to avoid creating a second class of stock. Alternatively, the agreement could contain a broad provision saying that the corporation will use its best efforts to avoid a termination of S status.

One-class-of-stock restriction

Another important S corporation requirement to consider in a buy/sell agreement is the one–class–of–stock rule. Under this rule, an S corporation is prohibited from having more than one class of stock. If it does, the corporation’s S election is automatically terminated. If restrictions are placed on some shares (e.g., those held by employees), the one–class–of–stock requirement may be violated.

Estate and gift tax

A buy/sell agreement that avoids violating the one–class–of–stock rule may still be disregarded for federal estate and gift tax valuation purposes. For example, if a binding buy/sell agreement sets a price for the shares of a deceased S shareholder that is less than the estate tax value, the estate will have to pay tax on the higher amount. But the heirs will receive sales proceeds based on the lower value set by the buy/sell agreement. Thus, it is critical that the price set by the buy/sell agreement be respected for federal estate tax valuation purposes.

Installment redemptions

When redemption payments are made in installments under a stock buy/sell redemption agreement, the corporation will issue a note to the person whose stock is being redeemed. In such cases, care must be taken to prevent the intended debt from being recharacterized as equity by the IRS. If this happens, the recharacterization may result in a second class of stock, which would invalidate the corporation’s S election (Sec. 1361(b)(1)(D)). The owners should consider restrictions in the buy/sell agreement to ensure that any debt owed under an installment redemption transaction be respected as debt for tax purposes. Furthermore, the agreement could require that the debt meet the straight–debt safe harbor underSec. 1361(c)(5) and provide a stated interest rate (at least equal to the applicable federal rate) to avoid any imputed–interest problems.

Estate planning

Shareholder eligibility

When implementing a buy/sell agreement, estate planning concerns must be taken into account. Some entities used in estate planning are not permitted to be S corporation shareholders (e.g., trusts that do not meet certain requirements). Therefore, the buy/sell agreement should require the decedent’s estate to sell the shares before transferring them to a disqualified person or trust.

Where a trust is an existing shareholder, the trust agreement should be reviewed to ensure the trust is an eligible shareholder underSec. 1361(c)(2). In addition, to ensure the trust remains an eligible shareholder, the buy/sell agreement should probably provide some restriction on amending the trust agreement of any eligible trust that holds S stock without first gaining approval of the corporation’s officers.

The buy/sell agreement should also be reviewed for other potential conflicts between the estate plan and the desire of the shareholders to maintain S status.

Establishing a buy/sell price

Often, shareholders use a buy/sell agreement to establish the stock’s sale price for estate tax purposes. This value generally determines the estate’s stock basis (Sec. 1014).

In valuing an S corporation, certain aspects of S status should be considered, including the fact that an S corporation shareholder is taxed currently on earnings, whether distributed or not. The formula or stated price may reflect a credit for the shareholder’s allocable share of the accumulated adjustments account and/or the accumulated earnings and profits, both of which affect the taxability of future distributions. An alternate pricing formula should be provided in the event S status is terminated, whether voluntarily or involuntarily.

Furthermore, an adjustment to the purchase price would be appropriate if the corporation has exposure to built–in gains or passive income taxes.

Adjusting stock basis

The estate’s stock basis increases by any S corporation income allocated to the estate. Thus, the decedent shareholder’s estate incurs a capital loss equal to the amount of Schedule K–1, Shareholder’s Share of Income, Deductions, Credits, etc., income when the stock is sold. This problem can be avoided by distributing to the estate an amount equal to the income allocation. This reduces the estate’s basis in the stock back to the amount determined under the buy/sell agreement, resulting in no gain or loss on the sale. However, S corporation distributions must be pro rata to all shareholders to comply with the one–class–of–stock rule, so all shareholders would have to receive proportionate distributions.

Income allocations

The buy/sell agreement should provide for the allocation of income and loss items in the event a shareholder either terminates their interest in the S corporation or the corporation terminates its S status. The allocation of income and loss items can affect:

• The taxability of distributions to the shareholders;
• The terminating shareholder’s stock basis for determining gain or loss upon disposition; and
• The stock basis of the remaining shareholders.

The shareholders should consider including in the agreement the requirement to allocate income and loss items using the specific accounting method if an owner terminates their entire ownership interest during a year or there is a qualifying disposition of the stock. This is an alternative to the default per–share, per–day allocation method. This method results in allocating tax items to the pre– and post–termination periods of the year during which they actually occur. The specific accounting method must be elected by the corporation and consented to by all affected shareholders in the case of a complete termination (Sec. 1377(a)(2); Regs. Sec. 1.1377–1) or by all shareholders who held stock at any time during the year for a qualifying disposition (Regs. Sec. 1.1368–1(g)(2)).

When a buy/sell agreement requires that the specific accounting election be made upon a complete termination or qualifying disposition, the shareholders may want to simultaneously execute powers of attorney authorizing one or more persons to consent on their behalf if and when the election is made. This reduces the administrative burden of obtaining consents in the future.

Revocation and termination of S status

Buy/sell agreements often address revocation and termination of S status. Agreements often provide for voluntary revocation of S corporation status if certain conditions are met.

With respect to S corporation terminations, the agreement can address:

• Distributions during the post-termination period;
• Allocation of income and loss items during the S termination year; and
• Shareholder participation in obtaining an IRS waiver-of-inadvertent-termination relief request.

Events triggering the buy/sell agreement

Events triggering the buy/sell agreement should be specified by the shareholders, although triggering events typically include circumstances causing a shareholder to dispose of their stock, voluntarily or involuntarily. Typical triggering events include but are not limited to:

• The shareholder’s death;
• In a community property state, the death of a shareholder’s spouse;
• The shareholder’s disability;
• The shareholder’s divorce where one spouse remains active in the business;
• The shareholder’s insolvency or bankruptcy, raising the risk of the stock falling into the hands of creditors who may not be eligible S corporation shareholders;
• The shareholder’s loss of a professional license, resulting in an inability to continue to practice in a profession;
• The shareholder’s conviction of a crime, resulting in incarceration, an inability to practice in a profession, or an inability to sell goods or services due to scandal or public disgrace;
• The shareholder’s retirement or pursuit of another line of work;
• The shareholder’s desire to sell the stock and withdraw from the business before retirement; and
• Disagreement between the shareholders (e.g., an inability to make important business decisions due to deadlock).

Death of a shareholder

The death of a shareholder is a major disruption for closely held businesses. Often, the shareholder’s heirs become unwanted participants in the business. To minimize these risks, most buy/sell agreements provide for the mandatory purchase (by the entity or the other shareholders) of a shareholder’s interest in the business at death. In other circumstances, the shareholders may not be concerned about the new shareholder but instead may be concerned about their family being able to cash out. In that case, the agreement may be structured as a put option on the part of the deceased shareholder’s estate, so that the family has the option to continue to participate in the business or convert the interest to cash.

Disability

A shareholder’s disability is another circumstance the agreement should address. The mandatory purchase of a disabled shareholder’s interest helps ensure that those contributing to the success of the business are the ones rewarded. This is important in an S corporation, where each shareholder must be allocated a pro rata share of the business profits. Absent this provision, the disabled shareholder would share in profits or appreciation generated through the other shareholders’ efforts.

The problem of defining a qualifying disability is compounded because it can be a physical or mental condition. It may also be a temporary or permanent condition. When disability buyout insurance is used to fund the purchase, it is best to incorporate the policy’s definition of disability into the agreement to eliminate the need to make an independent determination of whether a shareholder is disabled. This also eliminates the risk that the shareholder will be considered disabled under the buy/sell agreement definition without being certified as disabled under the policy (a disastrous result, since the proceeds from the policy are needed for the buyout).

Another option is to designate an independent third party to make the disability determination, such as one or more physicians who are independent of the shareholders. Giving one or more shareholders the responsibility of making the determination presents a conflict of interest that could impair the ability to make an objective decision.

Divorce

One of the most common and potentially disruptive ownership transfers occurs when a shareholder gets divorced. All too often, the business is the shareholder’s largest asset. In family businesses, the problem may extend to the spouses of children who are active in the business. The problem may be more pervasive in community property states where each spouse is considered to own half of all community property. The disruption can be reduced by granting the divorcing shareholder a right of first refusal to acquire any transferred stock, which allows the divorcing shareholder to maintain their present ownership in the business. If the divorcing shareholder cannot or will not purchase the stock, the other shareholders or the corporation can be given the right to purchase the shares under the same terms.

Practice tip: To establish that the spouse had knowledge of the transfer restrictions, it is advisable to have each shareholder’s spouse be a party to the buy/sell agreement. In addition, the price established by the agreement should be set fairly. The authors recommend setting the same price and terms as would apply on death or retirement to ensure the spouse is treated the same as the shareholders. These measures increase the likelihood that the provision will be enforceable.

Retirement

Some buy/sell agreements are triggered by a shareholder’s retirement or other lifetime separation from the business. The agreement may provide for a mandatory purchase of a departing shareholder’s stock. Alternatively, the agreement can be used to protect the remaining shareholders by restricting the departing shareholder’s ability to transfer the stock. This type of agreement will grant the remaining shareholders an option to purchase the departing shareholder’s shares. If the remaining shareholders exercise the option, the departing shareholder is required to sell. If the shareholders do not exercise their purchase option, the departing shareholder is free to find an outside buyer.

Shareholder disagreements

Finally, a trigger clause dealing with unsolvable shareholder disagreements (i.e., a “Russian roulette” or “push–pull” provision) is sometimes included, allowing any shareholder to make an offer to purchase the interests of the other shareholders. The offering shareholder sets the price and terms. The other shareholders then have a specified number of days to either sell their stock to the offering shareholder or buy out that shareholder at the same price and terms. The offering price and terms will be reasonable because there is no way to know whether a person will be a buyer or a seller.

While this arrangement may work well with a small number of shareholders, it may be too cumbersome with a larger group. It also can present problems when there is a significant disparity in wealth among the shareholders, since the wealthy shareholder can offer a price below market value, knowing the cash–poor shareholder(s) cannot meet the offer. This would enable the wealthy shareholder to obtain the shares at a low price.

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Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint.

For more information about this column, contact thetaxadviser@aicpa.org.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s S Corporations topic. Published by Thomson Reuters, Frisco, Texas, 2025 (800-431-9025; tax.thomsonreuters.com).