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Use of Buy-Sell Agreements in Closely Held Businesses  

Buy-sell agreements are used to plan for ownership succession in small businesses. Where a business is owned by two or more unrelated individuals a buy-sell agreement can be used as a mechanism to provide liquidity for an owner’s heirs upon his or her death. In a family-owned business it often has the fundamental purpose of keeping the business in the family. In both cases, it can also function as a means for resolving irreconcilable differences among the owners.

A buy-sell agreement is an agreement by which a business owner who is relinquishing his or her ownership has either the right or the obligation to sell that interest, either to the remaining owners or to the business itself, upon the happening of certain events called trigger events. Common trigger events include retirement, death, disability, desire to liquidate and decision deadlocks among the owners. A buy-sell agreement can be used in any type of multi-owner entity: S corporation, C corporation, partnership or limited liability company. It can be an essential estate planning tool as well, particularly in cases where an interest in a business is a major portion of the estate.

Types of buy-sell agreements and how they work. There are two basic types of buy-sell agreements, cross-purchase and redemption agreements. In a cross-purchase agreement, the departing owner sells his or her interest to the remaining owners. In a redemption agreement, the interest is sold back to the company. A buy-sell agreement can have various features which must be carefully tailored to fit the particular personal and business needs of the participants. Some common features include the following: Call rights give the remaining owner or owners (or the company, in the case of a redemption agreement) the right, but not the obligation, to buy the departing owner’s interest at pre-determined price. Put rights give the departing owner (or his heirs or estate) the right, but not the obligation, to sell his interest back to the company or the remaining owners at a pre-determined price. A mandatory sale agreement requires the departing owner to sell and the remaining owners (or the company) to buy the interest. Another type of agreement places restrictions on the departing owner’s right to dispose of his investment. A right of first refusal requires the departing owner, before he can sell to a third party, to offer to sell back to the company or other owners under the same terms and conditions. This restriction has the drawback of making it difficult for the departing owner to find a buyer on reasonable terms since the would-be buyer knows that the other owners can preempt his deal at any time. Therefore another mechanism has evolved known as a right of first offer. Under this arrangement, the departing owner must make an offer to sell to the remaining owners. If that offer is refused, the departing owner is free to sell to a third party on the same terms. A more straight-forward restriction is one which simply prohibits the sale of an interest without the consent of the other owners.

Price and funding. A buy-sell agreement must determine a price for the departing owner’s interest. This is often the most difficult part of the agreement to work out. The price can either be a fixed price, possibly with provisions for periodic updates, a price determined by a formula, or a price determined by appraisal. Formulas for determining the sale price include book value (or a multiple thereof), and a capitalized earnings approach. Another approach which is sometimes found in agreements meant to resolve irreconcilable business differences is the "Russian roulette" feature. This provision allows one owner to name a value for his interest. The other owner or owners must then decide either to buy out the interest of the naming party or to sell him their own interests at the stated price.

A buy-sell agreement would not work if the other owners did not have the funds to pay the required price. For this reason, the agreement usually contains funding requirements. If the agreement is a redemption agreement, the company can sometimes accumulate a surplus which can be held in the form of liquid investments and used to pay the departing owner upon the happening of a trigger event. If the company is a C corporation, however, special care must be taken not to trigger the accumulated earnings tax. The agreement could also allow the company or other owners to pay the purchase price, with interest, over a period of years. This method, aside from helping the remaining owners manage cash flow, can also have income tax benefits for the seller. A deferred payment can allow the seller (or the seller’s heirs) to pay any income tax on the installment method. If the payment is to be made over the remaining life of the seller or the seller’s heir it can be structured to qualify as a "private annuity" under Internal Revenue Code section 72. A private annuity is a transaction in which the deferred portion of the purchase price is dependent in whole or in part on the life of the withdrawing owner. It is a private annuity because the annuity payments are not made by a commercial insurance company. The withdrawing owner reports the payments for tax purposes by dividing each into three parts: a tax-free recovery of basis, which is determined under income tax life-expectancy tables; a capital gain portion; and an ordinary income (interest) portion. Upon death, the payments and the tax reporting stop.

A common funding mechanism is the use of life insurance. For example, in a redemption agreement, the company would purchase "key-man" insurance on each of its owners’ lives. In a cross-purchase agreement, each owner could be required to carry a life insurance policy on the life of another owner. When a triggering event occurs, the insurance proceeds (if the triggering event is death) or cash value is used to purchase the withdrawing owners’ interest. A cross-purchase agreement funded in this way could, however, run into problems. If the owners are of different ages and in differing health, the premiums will vary considerably. In addition, owners will generally want assurance that their co-owners will live up to their responsibility to pay the premiums and keep the insurance in force. These latter problems can be solved by means of a trust which is set up to hold the insurance policies. The trust will become a party to the buy-sell agreement and will be obligated to use the insurance to purchase an owner’s interest when a triggering event occurs. If this course is chosen, care must be exercised in drafting to assure that the trust will qualify as a grantor trust under the tax laws. Failure to meet this requirement could cause severe income and estate tax problems.

Tax considerations. Some of the income tax considerations have been touched upon above. Apart from these, other tax considerations include:

• How a deceased owner’s estate will value his interest and how this value is affected by the buy-sell agreement;

• Whether insurance policies or proceeds will be included in the estate;

• The income tax implications to the insurance trust;

• The income tax implications of a premium-leveling mechanism;

• The income tax effect of a redemption vs. a cross-purchase agreement;

• The income taxation of the life insurance proceeds;

• Whether the insurance premiums are deductible;

• The special income tax exclusion of gain under Code section 1202;

• Use of an Employee Stock Ownership plan;

• Accumulated earnings and alternative minimum tax;

• The ability to pay the estate tax in installments under Code section 6166;

• The special use valuation provisions for real estate and family businesses under Code sections 2032A and 2033A.

Each of the above should be considered by a qualified tax professional in the pre-implementation planning for a buy-sell agreement.

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