Although many small business owners envision passing along the company to children or other family members, without proper business succession planning, transfer taxes and liquidity problems often cause even the most successful businesses to be sold or liquidated upon the death of a key owner. One problem that frequently arises, either on the death of a key owner or on the termination of a shareholder, is that some shareholders want to continue the business while others want to sell out. Implementing a few planning techniques may insure the smooth and successful transfer of a closely held business to shareholders who wish to continue to operate the business and provide value to those who want to sell their interests.
Sometimes referred to as a stock purchase agreement, a buy-sell agreement is an arrangement entered into by the shareholders of a corporation that imposes restrictions on the transferability of the stock held by each of the parties to the agreement. The use of a binding agreement by the shareholders of a closely held corporation can assure that:
- a shareholder can convert his/her stock in the business into liquid assets for retirement income
- shares will be sold only to parties approved by the other shareholders
- a shareholder’s beneficiaries can receive diversified assets upon the death of a shareholder
- valuation of the stock for estate tax purposes is established
There are two basic types of buy-sell agreements; the cross-purchase agreement and the stock redemption agreement. It is also possible to establish a combination of the two types. While these agreements can be drafted to allow some discretion as to the purchase obligations, buy-sell agreements can only be truly effective in certain situations if they include mandatory purchase provisions.
- Cross-purchase agreement. A cross-purchase agreement is an arrangement solely between the shareholders of a corporation in which the shareholders that intend to remain with the corporation purchase the shares of a shareholder who is retiring or who has died.
- Stock redemption agreement. A stock redemption agreement requires the corporation to purchase or redeem the stock of a retiring or deceased shareholder, and can also provide for redemption under other circumstances, such as employment termination.
- Combination agreements. A buy-sell agreement can be drafted to require the corporation to redeem a certain amount of shares and the remaining shareholders purchase the remaining shares, or it can provide for the shareholders to get first option to purchase as many shares as they desire and then require the corporation to redeem any remaining shares.
Funding can be the key to carrying out the provisions of a buy-sell agreement. A common solution is life insurance purchased on the lives of key shareholders. For redemption agreements, the corporation purchases the policy and pays the premiums. With cross-purchase agreements, the shareholders must purchase policies on each other. This can get quite complicated for corporations with many shareholders. For example, if a corporation has six shareholders, 30 insurance policies are needed and reliance is placed on the continued payment of premiums by the shareholders. If a stock redemption agreement is used, the company purchases one policy on the life of each shareholder, greatly reducing insurance costs and simplifying implementation of the agreement.
A buy-sell agreement that provides for installment payments over several years to purchase the shares of a retiring shareholder is a simple way to provide a stream of income for retirement. The value of the installment payments should be based on the current value of the stock plus a reasonable interest component. The retiring shareholder would only have the status of an unsecured creditor of the corporation. To provide more security, the corporation may consider financing the stock redemption with an annuity; however this would be subject to the available cash assets of the corporation.
Often an important concern for small businesses, buy-sell agreements can be used to restrict the involuntary transfer of shares, i.e. the transfer of shares to a creditor or to an estranged spouse as part of a divorce settlement. The most common method of dealing with this issue is to provide for the automatic offer of stock subject to an involuntary transfer to the company and/or the remaining shareholders immediately before an involuntary transfer would otherwise take effect.
Finally, establishing the value of shares is important because the value of shares owned by a shareholder of a closely held corporation is one of the most heavily litigated and intensely disputed issues in any of the situations described above. A buy-sell agreement can set the price, usually with a formula, which can be definitive in all those situations except death of a shareholder.
The IRS often takes the position that the actual value of stock in a closely held business owned by a deceased shareholder is significantly greater than the value of stock reported by the estate, resulting in substantially higher estate taxes owed by the estate. The worst case scenario is that the IRS successfully challenges the buy-out price. The estate would then find itself in the undesirable position of receiving a contractual agreement price for the shares that is lower than the valuation upon which it pays estate taxes. One way of dealing with that problem is to assume that an outside appraisal will be needed and provide in the buy-sell agreement that the price of the shares on the death of a shareholder will be governed by the price accepted by the IRS.
Proper planning is the key to a successful transfer of a small business. A succession plan guided by a knowledgeable attorney can prevent unnecessary hardship on the business and its owners.