By: Boyd Hudson, Esq.
Shareholders in a transaction to acquire an automobile dealership should seriously consider using the Buy-Sell Agreement to spell out exactly what will happen to a shareholder’s stock in the event of his or her death, disability or retirement.
The use of such agreements for business continuation purposes can prove particularly advantageous to owners wishing to attain the following objectives:
Continuity
The agreement can insure that the business will remain in the hands of the original shareholders and keep the business from falling into the hands of outsiders. Frequently the agreement accomplishes this by providing for the purchase of the shares by the remaining shareholders at a pre-determined price. The remaining owners will thus avoid a source of potential conflict.
Establish Value
An agreement can establish the value of the business for federal estate tax purposes. If such an agreement does not exist, the owners will need to determine the value to be placed on the decedent’s business interest and convince the IRS that this value should be accepted. (However, merely because the executed buy-sell agreement sets the value of the stock does not necessarily mean that the Internal Revenue Service will respect it for estate tax purposes. The IRS often feels such agreements are being used to abuse the transfer tax system with businesses being transferred with below-market purchase and sale restrictions. Federal tax legislation was enacted in 1990 in an attempt to deal with the perceived abuses.)
Provide Cash
An agreement (with proper funding mechanisms) can provide liquidity to the family of the deceased, disabled or retired shareholder. Thus an agreement can help the family convert a business interest into cash.
Prevent Shareholder Disagreement
An agreement can avoid the situation of a remaining shareholder(s) having to share a business with the family of a deceased co-shareholder.
To Create a Market
A business continuation agreement can provide a market for the business interest.
Definitions and Objectives
A business continuation agreement is defined as an arrangement for the sale, transfer or other disposition of the stock or a partnership interest in the event of the death, disability, retirement or other withdrawal of an owner of a corporation or a partner in a partnership. There are a number of different types:
- “Cross-purchase” agreement – where the individual owners or shareholders agree to sell their interests to each other in the case of a triggering event;
- “Redemption-type” agreement- where the agreement is between the business itself and the owners, whereby the corporation or partnership agrees to purchase the interests of the shareholders or partners;
- “Hybrid-type” agreement – often used where there is concern that the corporation may be unable to buy the stock of the selling shareholder. The remaining shareholders become the back-up market for the stock of the retiring or deceased shareholder.
Pricing and Funding Considerations
A critical consideration in a business continuation agreement is, what pricing or valuation mechanism should it use. There are a number of options available. The approach adopted should be appropriate for the facts that exist at the time of execution, yet be workable when the triggering event occurs. Basically, there are three different approaches that have been used.
- Exact or Fixed Price. This is the most straightforward. The parties should include provisions in the agreement that will allow the fixed price to be adjusted , in order to reflect changes in the value of the stock. One way is to provide for annual revisions of the price to be done at the same time each year. Another way is to provide that the value will be adjusted each year for changes in an external index such as the CPI.
- Appraisal. It is fairly common for the parties to include an appraisal provision to establish value. Often, there will be a provision to have three (3) appraisers, one selected by the buyer, one selected by the seller, and the appraisers to select a third. The agreement should specify who is to pay for the cost of the appraisal and how the appraisers are to be selected. The agreement should also give some guidance to the appraisers on what procedures or guidelines are to be used in making the appraisal. For example, is book value or fair market value, or some other value to be used in appraising the value of assets?
Formula Price. Formula methods are often used to take into account net profits and/or goodwill. One formula method uses the capitalization of earnings. Under this method the value is determined by averaging the earnings of the corporation over a set period (e.g. 5 years) and capitalizing those average earnings by an agreed percentage. Another method is book value. However, the use of book value requires one to look very carefully at the accounting methods used by the business. If the business is on the accrual method of accounting, it would be necessary to look at the amount of accounts receivable and accounts payable and take these items into account. Book value traditionally means “historical cost” and will not necessarily reflect appreciation or depreciation in the value of assets. Usually there is some goodwill that is not reflected on the books of the business.
There are a number of ways that a business continuation agreement can be funded
- Self-Funding. The purchasing party can agree to finance the purchase himself with his own resources. If the buyer provides all cash, the seller is happy. If the buyer is planning to pay off with installments using a note, the seller would like to see some form of security. The installment note may be secured by a pledge of the stock interest or other assets. The note should have a reasonable rate of interest. To be safe from a tax standpoint, and to avoid the imputed interest rules, the note should not be at a rate less than the Applicable Federal Rate (AFR), currently around 8%.
- Sinking Fund. This is a variation of self-funding. The business can set aside an annual amount into a fund while all stockholders are still alive. The problem is that the funds are a drain on corporate resources. In addition, putting money into a sinking fund may expose the corporation to the accumulated earnings tax under Internal Revenue Code Section 531.
- Life Insurance. It is very common for parties to fund a business continuation agreement with life insurance. In the case of a cross-purchase agreement, the shareholders own insurance on each other’s life. In the case of a stock redemption agreement, the corporation purchases insurance on the life or lives of the shareholders and it owns the policy. Life insurance is a great funding vehicle if the triggering event is the death of a shareholder. However, if the event that triggers the buy-out is disability or retirement, life insurance will not be adequate, unless there is sufficient cash value in the policy to accomplish the purchase.
- Disability Insurance. Often the worst thing that can happen to a business is not for one of the owners to die, but for one of the owners to become permanently disabled. This is because the disabled shareholder still has to be cared for and can be a drain on profits without providing the leadership or management skills needed to produce the profits. The business should consider the purchase of a disability policy to cover this contingency. Policies can be purchased with long waiting periods that allow the parties to assess the extent of the disability.
CROSS-PURCHASE VERSUS REDEMPTION
There are situations where it is preferable to use a cross-purchase agreement rather than have the corporation redeem the stock. In other situations a redemption is preferable. These situations include the following:
- Number of Shareholders. If the number of shareholders is small, for example one to three, a cross-purchase is preferable. In this case, the shareholders can purchase life insurance on the other shareholders’ lives without there being too many policies. If there are many shareholders, a cross-purchase agreement funded with life insurance becomes unwieldy.
- State Corporate Laws. The laws of many states prohibit a corporation from making a redemption of its shares which have the effect of making the corporation undercapitalized. See e.g. Calif. Corp. Code §500. If there is a concern about the effect a redemption might have, a cross-purchase agreement which does not directly involve the corporation may be preferable.
- Percentage Ownership Issues. A redemption works well when the ownership of stock is equal or close to equal among the shareholders. If the ownership is unequal, a cross-purchase agreement is preferable.
For example, assume that in the ABC partnership A owns 80%, B owns 10%, and C owns 10%. If A gets bought out, he will be receiving primarily his own money back, while transferring the whole business to the minority shareholders.
- Relative Tax Brackets of Corporation versus Shareholders. If the corporation is in a higher tax bracket than the shareholders, it is probably more economical for the corporation to pay out amounts to the shareholders which they can use to fund the purchase of life insurance. This is because the corporation can deduct the salary payments but it cannot deduct the payment of life insurance premiums. One issue to be careful of here is that there may be limitations on the ability of the corporation to increase its payments to the shareholders, principally that the payments may be considered a dividend and not deductible to the corporation. If the corporation is in a lower bracket, it makes more sense for the corporation to fund a redemption agreement with life insurance. This also avoids the problem of “unreasonable compensation” to the shareholders and potential dividend exposure.
A future issue of California Showroom will address some of the income tax and estate tax considerations associated with business continuation agreements.
(Mr. Hudson is formerly of Counsel to the law firm of Manning, Leaver, Bruder & Berberich.)
This article was written in 1997.