| 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. |
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