Succession Planning

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Controlling Your Destiny with a Buy-Sell Agreement

Buy-sell agreements can be powerful tools to help you control your business’s destiny. These contractual agreements typically involve shareholders and their corporation or are executed between a shareholder and the other corporate shareholders. Partners or limited liability company (LLC) members can also enter into buy-sell agreements.

A buy-sell agreement controls what happens to a business when a specified event occurs, such as a shareholder’s death or disability. It is a contract under which each owner agrees to offer that owner’s interest in the business either to the business or to the other owners of the business upon the occurrence of certain events. An agreement might provide that, when a shareholder dies, the corporation will buy back the stock (a redemption plan) or that one or more of the remaining shareholders will buy the stock from the deceased’s estate (a cross-purchase plan). A buy-sell may also address the management of the business and how the purchase will be funded or restraints on competition.

A buy-sell is not a static document. It is subject to frequent change.

A well-drafted buy-sell agreement can help solve several estate planning problems for the owner of a closely held business. An agreement also may help protect and preserve the business against internal squabbles, whether among family members or unrelated business owners.

A key issue with any buy-sell agreement is providing the buyer with a means of funding the purchase. Life or disability insurance often fulfills this need. Using insurance to fund a buy-sell agreement can give rise to several tax and nontax issues and opportunities.

Because shareholders typically expect a business’s value to rise, the price under the buy-sell agreement will likely also change. Thus, funding through insurance must be adjusted over time and periodically reviewed to ensure adequate coverage.

Potential Benefits of a Buy-Sell Agreement

Among other qualities, a well-drafted agreement:

• Provides a ready market for the shares if the owner’s estate wants to sell the stock after the owner’s death.

• Sets a price for the shares. In the right circumstances, it also fixes the value for estate tax purposes.

Allows a stable continuation of the business by preventing unnecessary disagreements caused by new, unwanted owners.

There are three basic structures of a buy-sell:

1. Cross-purchase: the trigger is when the remaining owners are the buyers of the withdrawing owners interest.

2. Redemption: the trigger is when the business is the purchaser of the withdrawing owner’s interest.

3. Hybrid: involves components of a cross-purchase and redemption.

In a business with only two shareholders, a cross-purchase plan is relatively simple: Each owner need only apply for and hold a life insurance policy on the other. As the number of shareholders grows, however, the number of policies involved increases dramatically. Three shareholders would need six policies (each shareholder would have policies on the two others), while a business with six shareholders would need 30 policies. This need for multiple insurance policies, paid for outside of the business, creates the complexity that has traditionally been cross-purchase agreements’ major drawback.

Of course, shareholders spend their own money every year for these insurance costs. Premiums will vary for each policy — sometimes significantly — depending on each individual’s age and other insurance rating factors, as well as his or her ownership percentage. Such amounts can generally be paid as additional compensation to each shareholder, but to fully cover the cost, the additional compensation would have to be “grossed up”.

Gross-up of additional compensation

Cash compensation:                         $1,667*
Income and payroll taxes (40%)    $(667)
Net cash to shareholder                   $1,000
* For a $1,000 insurance premium

Yet in businesses with very disproportionate shareholdings, such as 90/10, it may not be fair to the majority shareholder if the company funds the insurance (either directly or through salaries). In such cases, the 90% shareholder would effectively pay 90% of insurance costs on his or her own life and thus end up paying for most of his or her own buyout. You will need to closely examine the overall agreement’s economics to understand how it will affect those involved.

In a cross-purchase agreement, the party who receives the proceeds should maintain the policy. The insured, however, is the one who will suffer if a policy lapses and leaves insufficient funds for the purchase of his or her share of the business. Yet many agreements fail to provide a means to notify the insured if premiums are not being paid. This problem can usually be solved by verifying that each policy owner has provided evidence to the insured that premiums have been paid and permitting the insured to pay premiums and then seek reimbursement.

With a redemption agreement, the corporation itself buys back a shareholder’s stock. Thus, this type of agreement proportionately increases each remaining shareholder’s ownership. This may or may not be the desired result, because a big difference may lie between what each shareholder wants and what each will end up with under a redemption plan. If a proportionate distribution of shares is not the goal of your buy-sell agreement, you may want to use a more flexible cross purchase plan.

A redemption does not provide the remaining shareholders of a C corporation with an additional tax basis in their newly acquired stock. Assume, for example, that two 50% shareholders each paid $500 for their stock when they started a business. When Shareholder One dies, his stock is redeemed for $1 million. Shareholder Two (now the 100% shareholder) still has a tax basis of $500 in her stock. By contrast, under a cross-purchase arrangement, Shareholder Two’s stock would now have a tax basis of $1,000,500.

Redemptions also can cause a potential income tax problem for C corporations, because receiving life insurance proceeds, while not taxable for regular tax purposes, can result in additional tax under the corporate alternative minimum tax (AMT). When insurance proceeds are large in relation to a business’s net income, the AMT could be substantial. This often occurs in shareholder buyouts.

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