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Consulting / Succession Planning

Make the Most of Buy-Sell Agreements

These complex contracts solve many problems.

By Thomas F. Burrage and Chad Hoekstra
October 2004
EXECUTIVE SUMMARY
BUY-SELL AGREEMENTS LET OWNERS, or shareholders and a corporation, agree to the terms and conditions of a future sale to smooth the transfer of an ownership stake under certain triggering events. They also provide a framework for establishing the purchase price of a business interest when an owner leaves or dies.

CPAs CAN HELP CLIENTS UNDERSTAND the details of buy-sell agreements and work with a team of professionals (such as an attorney, an insurance agent and an ABV) to ensure an agreement is correctly prepared. Misunderstandings over the interpretation of terms often are at the core of owners’ disputes about the value of their respective interest.

TYPICAL BUY-SELL AGREEMENTS will specify the type of the agreement, triggers that cause a mandatory or an optional buyout, a determination of the appropriate valuation date imposed by the agreement, the payment terms of the buy-sell obligation, methods by which the agreement will be funded, noncompete agreements between the parties as well as transfers of an owner’s interests permitted and prohibited by the agreement.

ALL TYPES OF CLOSELY HELD BUSINESSES can use buy-sell contracts. The two most common types, cross-purchase and redemption agreements, typically use insurance to fund the purchase of ownership interests.

TO DRAFT AN AGREEMENT that satisfies all owners and precludes future conflict, the owners need to understand their goals, the transaction’s ramifications and their options. Each party has rights, obligations, tax considerations and financial consequences. CPAs can help facilitate discussion to clarify owners’ choices.

THOMAS F. BURRAGE, CPA/ABV, is the litigation and valuation services partner in charge at Meyners & Co. LLC in Albuquerque, New Mexico. He is coauthor of Divorce and Domestic Relations Litigation, recently published by John Wiley. His e-mail address is tburrage@meyners.com . CHAD HOEKSTRA, CPA/ABV, is a member of the Bennett/Thrasher litigation support and business valuation services group in Atlanta. His e-mail address is choekstra@btcpa.net .

usiness owners often ask CPAs about how useful buy-sell agreements can be for them. The answer is “very.” A buy-sell contract helps solve many problems at an unsettled juncture. It lets business partners, or shareholders and a corporation, agree to the terms and conditions of a future sale. That can smooth the transfer of ownership interest under disruptive circumstances that may include a partner’s death, retirement, termination of employment, loss of a professional license, disability or divorce (or the transfer of ownership to a spouse), bankruptcy, insolvency or receipt of a third-party offer to purchase the business. Having an agreement gives an owner a ready market for his or her business interest, resolves estate liquidity issues, provides a framework for establishing the purchase price of the interest and reduces disputes. By ensuring transition stability, a buy-sell contract also improves morale among the owner group.

CPAs can help clients understand the details of these agreements to better work with legal and other professionals to draft a buy-sell contract. Where lack of an agreement or misunderstandings over the interpretation of its terms are the basis of owner disputes about the value of their respective stake in a company, CPAs also help resolve disagreements and determine whether a party may be subject to a penalty.

Typical buy-sell agreements will specify

The type of agreement.
Triggering events that cause a mandatory or optional buyout.
A definition of the valuation date imposed by the agreement.
A baseline purchase price and the terms of payment.
Methods by which the agreement will be funded.
Noncompete agreements between the parties.
Transfers of an owner’s interests permitted under the agreement.
Transfers prohibited by the agreement.

Note: It is not necessary that the same agreement apply to all owners of an entity.

Do the Math

“Under a cross-purchase buy-sell agreement, three owners of a business worth $600,000 would have to purchase $100,000 of life insurance on one another to fund an equal purchase of the deceased person’s share.

Source: “Insurance for Buy-Sell Agreements,” Financial and Tax Fraud Associates Inc., www.quatloos.com .

TYPES AND TRIGGERS VARY
Buy-sell agreements apply to all kinds of organizations including C corporations, S corporations, limited liability companies, joint ventures, limited partnerships and general partnerships. Depending on the nature and ownership of an entity, types and triggers will vary, but every effective agreement should anticipate funding, be kept up to date and provide for a procedure to determine the purchase price.

Two common types of buy-sell agreements—cross-purchase and redemption agreements—may use insurance to fund the purchase of ownership interests and are activated by a partner’s death or disability. A third type, considered a hybrid of these two, also is an option.

Cross-purchase agreement. Upon an owner’s demise, the remaining owners individually agree to redeem the business interest of the deceased. The most common way partners prepare for funding a purchase in the event of a death is to have each owner obtain life or disability insurance policies on the other partners in amounts sufficient to pay for the business interest.

The advantages of this type of agreement. The surviving partners typically receive any life insurance proceeds tax-free. The proceeds of those life insurance policies are not includable in the decedent’s estate. The agreement may or may not be acceptable to the IRS as defining the fair market value of the decedent’s business interest for estate tax purposes. If it is, the estate or its beneficiaries will have no income tax on the purchase of the owner’s interest, as the basis of the interest will be equal to its sale price. However, IRC section 2703 says an agreement that undervalues the business interest for estate-transfer purposes may be invalid.

The disadvantages of a cross-purchase agreement. Purchasing a life or disability insurance policy on the life of each of the other partners becomes increasingly complex to administer as the number of owners changes over time. A potentially disparate cost of life or disability insurance may exist among owners who are of different ages and health profiles (young partners may pay very high premiums to cover older, less healthy owners). If there’s no insurance, the funding will come from the aftertax income of the remaining owners. If a surviving owner must borrow to fund the buyout, the IRS may classify the interest paid on the borrowings as investment interest, delaying the deductibility of the amounts paid.

Redemption agreement. Under this type of agreement, the entity typically redeems the interest of the departing owner. It is responsible for financing the purchase, which may be funded by the immediate use of the business’s resources (such as corporate savings), a financing arrangement defined by the agreement, remaining owners’ personal savings or life or disability insurance on the life of the departing owner.

The advantages of this type of agreement. The business is responsible for its funding. The agreement may define the fair market value of the decedent’s interest for estate tax purposes. If so, the estate or its beneficiaries will have no income tax on the purchase of the decedent’s interest, as the basis of the interest will be equal to its sale price. If the agreement isn’t fully funded and surviving owners borrow to fund the buyout, interest payments to the estate will be deductible on the entity’s tax return.

The disadvantages of this type of agreement. If a corporate entity is the beneficiary of buyout insurance, the proceeds of the policy may be subject to the alternative minimum tax. A savings account within a corporation in anticipation of such an event may create accumulated earnings tax problems, and if the business is not a corporation, it may be difficult to save. In the event a divorce triggers the agreement, the respective ownership interest of the remaining owners will change.

Value
T
here are a number of ways to value a business interest when drafting a buy-sell agreement. Common avenues for establishing the value of an ownership interest include

Fair market value. “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” Under a fair market value standard, a 10% interest in a company valued at $100 might be worth $5 because of discounts for lack of control and lack of ready marketability.

Fair value. Fair value is typically defined by statute and case law in the state in which a company is organized and commonly is interpreted as what is fair or equitable. In some states this includes discounts for lack of control or marketability and in others it does not. In states in which fair value is not subject to discounts, it is typically a pro rata value of 100%. Broadly, 10% of a company worth $100 would be $10 under those fair value statutes.

Formula pricing. This method does not equal fair market value but is, rather, a means to estimate that value. Formulas appeal to many parties to buy-sell agreements because they are objective and inexpensive to determine. They may, however, miss subjective factors that influence fair market value. Clients using a formula price should revisit it periodically to make sure it’s still representative of their intentions.
Book value. Value is sometimes defined as net book value as recorded in the entity’s records, tax returns or as determined under generally accepted accounting principles (GAAP). This value may be based on a company’s financial statement, audit or tax return. Net book value is not typically indicative of fair market value.

Value based on insurance proceeds. In a buy-sell agreement, it is not uncommon for the purchase price of an interest in a closely held company to be the amount of an owner’s life or disability insurance policy proceeds. While this is a simple method, it may or may not approximate fair market value. This variance may cause problems for the redeemed owner.

Periodic review and consensus. A company with several owners may periodically hold meetings to review and update an agreed upon value.

Hybrid agreement. Also called the wait-and-see or combination agreement, this type of contract is an amalgam of the two categories above. It usually gives the issuing business the first right of refusal to buy the ownership interest and other owners the second option to buy. This order of consideration is important. If a C corporation, with accumulated earnings and profits, assumes a shareholder’s obligation to purchase another’s stake in a business, the IRS may impute to the shareholder a constructive dividend (that is, reclassify it as a dividend distribution; see “ Tax Pitfalls ”).

BUILD A GOOD TEAM
Buy-sell agreements, which formalize the wishes of two or more owners on an important issue, often are complex. Each party to the agreement has rights, obligations, tax considerations and financial consequences. Depending on the entity, preparing the contracts may involve a combination of consultants (to advise clients on succession issues), business valuators (to determine the entity’s value), tax professionals (to cite the relevant tax considerations and maximize value) and auditors (to deal with the contingent liabilities created by these off-balance-sheet agreements). Often a team of professionals from several disciplines develops the plans, which then are documented in the agreement.

Tax Pitfalls
I
mproperly structured buy-sell agreements can produce unintended results. Sometimes inexperienced practitioners will recommend drafting a stock-transfer agreement in a way that subjects either the buying or the selling party to unnecessary taxes. Such pitfalls include but are not limited to

IRC section 302. Some of the more common errors tax advisers make when helping create agreements involve violations of section 302, which applies to entities taxed as corporations. Redemption agreements, for example, can call for a sale of less than 100% of a shareholder’s interest in a company (as when an active shareholder wants to retire but maintain a reduced interest). However, the section 302(b)(2) substantially disproportionate requirement will not be met if, immediately after the redemption, the selling shareholder retains a 50%-or-greater interest in the combined voting power of all classes of stock entitled to vote.

In addition the section 302(b)(2) requirements will not be met if the shareholder retains an interest in the voting stock equal to, or in excess of, 80% of the voting stock he or she held before the redemption (in measuring these interests, section 318 constructive ownership rules apply).The 80% rule also applies to the corporation’s common stock (voting and nonvoting). On failing the section 302(b)(2) requirements, the redeeming shareholder’s limited interest redemption distribution will be taxed as dividend income, assuming one of the other redemption provisions is not met.

Section 302(b) problems can be avoided when a shareholder’s death triggers the buy-sell agreement if the redemption proceeds are limited to the amount of the shareholder’s estate tax and deductible funeral and administration expenses. In such a case, section 303 treats the transaction as a sale or exchange, regardless of the ownership percentage retained by heirs or other related parties. Other requirements also must be met.

Constructive dividends. Another common pitfall advisers on buy-sell agreements must consider involves cross-purchase agreements. If a cross-purchase agreement provides that continuing shareholders have a primary and unconditional obligation to buy shares on a triggering event, but the corporation instead purchases the stock under a secondary requirement in the buy-sell agreement, the purchase is treated as a constructive dividend to the continuing shareholders. In a properly structured redemption agreement, the continuing shareholders are not directly affected by the acquisition (except for an increase in their ownership percentages).
To avoid this problem, tax advisers can suggest structuring the agreement so that shareholders have an option to purchase the stock rather than an unconditional obligation to do so.

Source: “Buy-Sell Agreements—An Invaluable Tool,” a two-part series in the April and May 2003 issues of The Tax Adviser.

Teams may include some or all of the following players:

Attorney. Usually each party to a buy-sell agreement is represented by an attorney, who ensures an agreement protects an owner’s interest, correctly represents his or her wishes and bestows rights and obligations that are appropriate and enforceable under local law. If the attorney drafting the document also is a tax professional, he or she will make sure the document protects an owner from adverse tax consequences.

CPA. Buy-sell agreements create substantial financial benefits and obligations that affect both buyer and seller. CPAs understand the impact of those, both from the business and the individual perspective, and many are uniquely qualified to address important income tax considerations for the buyer and the seller, estate planning for individuals and the effect of the purchase obligation on the business.

Insurance agent. Because life and disability insurance are common methods of funding based on death or disability triggers, a competent insurance agent can address this consideration and be a key member of the team developing the funding of a buy-sell contract.

Valuator. There are a number of different methods for determining price in buy-sell agreements, and a business valuation professional with the training, experience and credentials such as the AICPA’s ABV can provide useful input into how the parties to the agreement can benefit from the plan.

THE AGREEMENT PROCESS
To draft a buy-sell agreement that satisfies all owners and precludes future conflict, the owners need to understand their goals, their options and a future transaction’s ramifications. CPAs can help clarify owners’ choices and facilitate discussion. One way to go about it is to gather all parties to the agreement and their advisers at a neutral, comfortable site.

RESOURCES
AICPA Resources
Publications

AICPA Code of Professional Conduct, www.aicpa.org/about/code/index.htm .

AICPA Statement on Standards for Consulting Services no. 1, Consulting Services: Definitions and Standards (paperback: # 005104JA; standalone document: # 055015JA).

Communicating in Litigation Services: Reports, A Nonauthoritative Guide—Consulting Services Practice Aid 96-3 (# 055000JA).

Conflicts of Interest in Litigation Services Engagements—Special Report 93-2 (# 055141JA).

Engagement Letters for Litigation Services—Business Valuation and Fraud and Litigation Services Practice Aid 04-1 (# 055298JA).

Litigation Services and Applicable Professional Standards—Special Report 03-1 (# 055297JA).

Conference
2004 Business Valuation Conference
November 7–9, 2004
JW Marriott Orlando Grande Lakes
Orlando, Florida

For more information, to make a purchase or to register, go to www.cpa2biz.com or call the Institute at 888-777-7077.

Discussion points the parties must resolve to implement a buy-sell agreement include but are not limited to

The definition of value the agreement will use (see “ Value ”). The options include using an objective formula such as multiple of earnings, multiple of revenue or multiple of book value. Some practitioners consider formulas objective (an advantage), but others say they may miss subjective factors associated with a business (a disadvantage).

Whether to employ an independent business valuator. If yes, the parties must decide how to select the professionals, how many to use and how to reconcile differences in valuations. If a buy-sell agreement directs the use of independent business valuators, the standard of value that appraisers use may be fair market value, fair value, investment value, intrinsic value or book value. (See “ Value ” and the International Glossary of Business Valuation Terms , www.bvappraisers.org/glossary/glossary.pdf .)

Periodic agreement of the appropriate value by the owners. Buy-sell contracts with this provision will need to be modified at regular intervals. Resolve how often the contract should be updated, how those changes will be documented and what happens if the agreement is not updated. Owners should ensure that all changes to the agreement are documented and properly executed.

The option to let the price and terms of an offer from a third party establish the price. The parties can decide to let a third party’s offer to purchase an interest in the entity set a price for the business interest.

IRS issues. Clients may mistake the contractual price set in a buy-sell agreement as the value for filing Small Business/Self-Employed Form 706, U.S. Estate Tax Return, for a deceased owner. If the value is based on a formula price rather than the standard of fair market value, the value may not be acceptable for estate or gift tax purposes. A buy-sell contract may not impose a binding value for federal estate tax purposes. If an agreement fixes the value of a decedent’s interest and the estate is redeemed for that price, the IRS can challenge the amount and assess estate tax on fair market value, which may be higher than the contractual buy-sell amount. Cases in which this has happened include Estate of H.A. True, Jr. and Jean D. True v. Commissioner, TC Memo 2001-167; Bommer Revocable Trust v. Commissioner, TC Memo 1997-380; and, most recently, Estate of George C. Blount v. Commissioner, TC Memo 2004-116. CPAs may want to advise clients to include a provision in the agreement that requires the purchase price on the death of an owner to be no less than the value of the shares “as finally determined for federal estate tax purposes.” (Also see “ Tax Pitfalls. ”)

PRACTICAL TIPS TO REMEMBER
To help facilitate discussion to clarify owners’ choices, gather all parties to the agreement and their advisers at a neutral, comfortable site.

Make sure the agreement anticipates the funding requirement of a buyout and includes a procedure to determine the purchase price.

Resolve whether and when the contract should be updated, how changes to it will be documented and what the consequences may be if the agreement is not updated.

Advise clients to include a provision in the agreement that requires the purchase price on the death of an owner to be no less than the value of the shares “as finally determined for federal estate tax purposes.”

Make sure the valuation provisions don’t provide an incentive for new shareholders to cause a triggering event and be bought out.

Work with other professionals, such as a lawyer, an insurance agent and an ABV, who are experienced in advising clients regarding the drafting of buy-sell agreements.

Penalty for leaving early/misconduct/involuntary misconduct. To dissuade shareholder employees from leaving the company, some buy-sell contracts give individuals who leave voluntarily or for misconduct as defined by the agreement less than they would otherwise receive. If an owner’s employment is terminated for cause, a “penalty price” such as net book value, some percentage of fair market value or a defined value may be applied.

A shareholder’s divorce. Many entities want to protect the business against an owner’s spouse obtaining an interest. If so, include language in the agreement to require purchase of a spouse’s ownership interest should he/she end up with stock in a divorce settlement. In any event, it is common to require the business owner’s spouse to become a party to the agreement. Spouses should have independent legal counsel. Note: If this provision is invoked, the divorcing owner’s interest in the business will be diluted.

New shareholders. New stakeholders may be required to be a party to existing buy-sell agreements before becoming shareholders. Make sure the valuation provisions don’t provide an incentive for them to cause a triggering event and be bought out (see “ Warning: Don’t Give Shareholders an Incentive to Sell ”).

BOTTOM LINE
Buy-sell agreements can be a valuable tool for closely held businesses and owners who want to protect their ownership interests. But if drafted improperly, these contracts can cause problems for both buying and selling parties. To ensure a satisfactory outcome, owners should work closely with their CPAs and a team of professionals such as an attorney, an insurance agent and an ABV to prepare an appropriate buy-sell agreement.

CASE STUDY
Warning : Don’t Give Shareholders an Incentive to Sell
W ithout a good understanding of the difference between the value specified in a buy-sell agreement and true economic value, parties to a buy-sell contract may unwittingly provide shareholders a financial incentive to cause a triggering event and get bought out.

In the case of ABC Corp., all shareholders, including the newest owner “A,” were party to a buy-sell agreement. Owner “A” had purchased his interest directly from the company based on a negotiated price tied to ABC Corp.’s GAAP book value. The negotiated price took into consideration a combined discount for lack of control and lack of marketability. However, terms of the buy-sell agreement included a buyout provision under certain triggering events using the term fair value . Several months later, in the midst of a disagreement with his co-owners, “A” realized the buyout agreement’s language would let him obtain more for his shares than he had paid for them. “A” caused a triggering event to occur and for his shares subsequently received “fair value,” which was finally determined to be a pro rata value of 100% of ABC Corp. “A” had effectively received a premium price over his negotiated buy-in price of only a few months prior.

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