Business Planning with Buy-Sell Agreements

A buy-sell agreement is an agreement among owners of a business (whether the business is conducted in the form of a partnership, limited liability company (LLC), or corporation) as to the eventual disposition of each owner's interest and can be a useful tool to achieve desired objectives. The owners of a closely-held business may enter into a buy-sell agreement to retain or transfer ownership and control of a corporation that provides a predetermined method of selling a deceased owner's interest in the business to the surviving owners. Buy-sell agreements are also used to restrict attempted dispositions of stock by stockholders during their lifetime (by sale or gift), in addition to restricting those who inherit from a deceased stockholder. Thus, a buy-sell agreement can effectively retain or transfer control among the stockholders during their lives and at their deaths. Such agreements are often funded by life insurance on the lives of the owners. Such funded agreements may take the form of a corporate redemption agreement or a cross-purchase agreement among the owners.

Buy-Sell Basics

Where there are two or more stockholders of a closely-held corporation, one of their chief concerns is likely to be whether the stock owned by any one of them may be sold, given or bequeathed to someone who is unacceptable to the other stockholders. For example, suppose that a controlling stockholder has given managerial control and some shares of stock to his oldest child, but has retained shares representing the controlling interest in the corporation. When the parent dies, the oldest child would be reluctant to see the parent's controlling shares pass to the spouse or to a younger child. The parent, too, may want to avoid a potentially disruptive disposition of his shares but his estate plan may call for leaving his shares to the spouse in order to benefit from the marital deduction. To make sure that control ultimately goes to the oldest child, the parent and the oldest child (or the corporation) may enter into a buy-sell agreement which requires the owner of the parent's shares following his death to sell them to either the older child or the corporation, depending on the type of buy-sell agreement.

The owners of a closely-held corporation or an S corporation may want to provide for a future orderly transfer of ownership and control of the corporation within the family, to a key employee, or to another shareholder, but without giving up ownership and control until some specified future time (often at death). This planning goal differs from that of an owner who is willing to make an immediate transfer of managerial control and all future corporate growth by means of a recapitalization, or of an owner who is willing to make an immediate transfer of ownership and control of the corporation by having the corporation redeem the owner's shares. Provision for a future transfer of ownership and control may be made through a buy-sell agreement whereby the stockholders of the corporation bind themselves contractually (with each other and/or with the corporation), to restrict the disposition of their shares only to other family members, key employees or specific shareholders or to the corporation, so that the ownership and control can remain as desired among a specific group of shareholders.

Benefits of Buy-Sell Planning

While buy-sell agreements can be an effective means of keeping and ultimately transferring ownership and control of a family corporation within the family, these agreements can serve other important planning goals. For instance, the buy-sell agreement can:

Typical Buy-Sell Agreements: Cross Purchase or Stock Redemption

The buy-sell agreement may be in the form of a stock redemption agreement between the corporation and the shareholders, a cross-purchase agreement among the shareholders, or a combination of both. These different types of agreements may have different tax and economic effects.

Stock Redemption Agreements

A typical corporate stock redemption agreement obligates the corporation to buy, and the shareholder to sell, his shares at the price or under the formula specified in the agreement upon the occurrence of certain specified events. Alternatively, or in addition, such an agreement may include a right of first refusal procedure that requires a stockholder who wants to sell out during his lifetime, first to offer to sell his shares to the corporation at a price or under a formula which is specified in the agreement. Only if the corporation turns down the offer can the stockholder then sell to outsiders. In considering a stock redemption agreement, note that it must also conform to any local law governing redemption of stock.



Cross Purchase Agreements

A typical cross-purchase agreement requires a stockholder who wants to sell out during his lifetime first to offer to sell his shares to the other stockholders. If they refuse to buy, only then can the stockholder sell his interest to outsiders. If a stockholder dies, or upon the occurrence of other specified events, the typical agreement requires the shareholder or his estate to sell, and the surviving stockholders to buy, his shares.

Combining Cross Purchase Agreements and Redemption Agreements

Cross purchase agreements and stock redemption agreements may be combined where so desired. For example, a corporate stock redemption agreement may cover a portion of a stockholder's shares, and a cross-purchase agreement may cover the remainder of his shares. Or, both the corporation and the other stockholders may be given rights of first refusal. For example, the other stockholders may be permitted to purchase stock offered to the corporation by the stockholder who wants to sell and which the corporation refuses to buy.

Using Life Insurance to Fund the Future Cost of Buying Shares of a Stockholder

In order to assure the availability of funds for the required purchase of a stockholder's shares, both the stock redemption and cross purchase types of buy-sell agreements may be funded with insurance on the life of the stockholder. Under the stock redemption agreement, the life insurance on a stockholder is bought and paid for by the corporation, and is made payable to the corporation. Under the cross purchase agreement, each stockholder buys, pays for and is the beneficiary of insurance on the lives of the other stockholders. Thus, each shareholder must purchase a policy on every other shareholder. For example, if A and B are the stockholders of a close corporation and want to fund their cross purchase agreement with life insurance, A will buy and pay for insurance on B's life, and B will do the same on A's life. If one dies, say B, A will collect the insurance from the policy he bought on B's life and A will therefore be assured of having the liquid funds needed to make his required purchase of B's shares from B's estate. Alternatively, under the cross purchase agreement option, it is possible to structure a cross-purchase plan which would require only one policy per insured owner by utilizing an escrowed ("trusteed") buy-sell plan. However, the plan must be properly implemented to avoid the transfer-for-value tax problems involved in the trusteed buy-sell agreement.

However, buy-sell agreements are sometimes not funded by insurance. The parties may feel that sufficient funds will be available from other sources, or that an installment pay-out will be arranged for the deceased stockholder's shares which will spread out the burden of payment to manageable levels.

IRS Requirements for Accepting Rights and Restrictions Set by Agreement for Valuation Purposes--Chapter 14 Rules

For gift, estate or generation-skipping tax purposes, rights and the restrictions set by a buy-sell agreement are disregarded in valuing property subject to the agreement, unless the agreement meets each one of the following requirements:

1. the agreement is a bona fide business arrangement;

2. the agreement is not a device to transfer the property to the natural objects of the transferor's bounty (family members, etc.) for less than full and adequate consideration in money or money's worth; and

3. at the time the agreement is entered into, the terms are comparable to similar arrangements entered into by persons in an arm's-length transaction.

Thus, for these purposes, the IRS would disregard a buy-sell agreement even if it is a bona fide business arrangement under (1) above if it is a device for transferring property from a parent to a child for less than full value under (2) above. The rights and restrictions of a buy-sell agreement are considered comparable to similar arrangements under (3) above if they could have been obtained in a fair bargain among unrelated parties in the same business dealing at arm's length. This would depend on the expected term of the agreement, current fair market value of the property, anticipated changes in value and adequacy of consideration for the rights given by the agreement. The rights and restrictions of a buy-sell agreement would be considered a fair bargain among unrelated parties in the same business if it conformed with the general practice of unrelated parties under negotiated agreements in the same business. General business practice cannot be shown by isolated comparables. Where comparables are difficult to find because a business is unique, comparables from similar businesses can be used. The IRS does not describe how the general practice of unrelated parties under negotiated agreements in the same line of business can be established. This would be especially difficult in the case of closely-held businesses.