Buy and Sale Agreements Cross Purchase Agreements GENERAL CONSIDERATIONS It is important that the principal shareholders of a closely held corporation consider a plan which will provide the most advantageous method (from a business, legal and economic standpoint) of liquidating their respective interests in the company at their deaths (and, perhaps, at retirement). This analysis outlines the mechanics which will assure a fair purchase price to the shareholder's family by a corporate stock redemption funded in advance, as well as assure the surviving shareholders of minimal managerial interference from the deceased shareholder's personal representatives. PRACTICALITIES The following business factors illustrate the value of a buy-sell agreement: The inadvisability of a decedent's heirs retaining an interest in a closely held corporation which, in the usual case, will not produce dividend income for them, due to its "double taxation." If the family should subsequently find it necessary to liquidate their interest, they would, in all probability, have no market for the stock other than the surviving shareholders, who could then purchase the decedent's interest at what could amount to a "Fire sale" price. The surviving shareholders, on the other hand, in the absence of a planned disposition of the stock at the death of one, might be faced with potentially dissident outside shareholders - i.e., the heirs of a deceased shareholder or even the heirs' vendees. AVOIDANCE OF PROBLEMS In order to avoid these complications, and to assure that the surviving shareholders (the ones who will run the business) shall own the company, and to assure the orderly continuity of the enterprise, the principals must consider the execution of a buy-sell agreement. When the parties do not wish the proprietary interest in a business to be retained by their surviving families, such buy-sell agreements are universally recommended by attorneys specializing in estate and business planning; indeed, such an agreement may be termed necessary. It is suggested that the principals enter into a buy-sell contract with one another. The contract will provide that, upon the death of a shareholder, the survivors shall be bound to purchase, and the decedent's estate shall be bound to sell, the decedent's stock on a pro rata basis. MULTIPLE SHAREHOLDERS Most people choose the redemption approach when there are multiple shareholders so that a large number of life insurance policies do not have to be issued. This problem is easily solved through the use of a trust which holds the policies and assures performance of the terms of the cross-purchase agreement. In many buy-sell situations a cross-purchase agreement is indicated in preference to a redemption agreement because: The purchase is to take place among family members whose relationship would cause a distribution in redemption of stock to be treated as a dividend, under I.R.C. Sec. 318 attribution rules, or The corporation has an accumulated earnings problem, and it is feared either the additional accumulation to pay premiums or the payment in redemption of stock, or both, would result in imposition of the penalty tax on unreasonably accumulated earnings, under I.R.C. Sec. 531, or The shareholders wish to have a different distribution of ownership after the purchase of a deceased shareholder's stock than would result from a stock redemption. The corporation is making use of tax preference items, and the death benefits or cash build-up would trigger the alternative minimum tax. FUNDING CONSIDERATIONS This agreement will only work if the funds are available on the date performance is demanded - i.e., at the death of one of the principals. It is generally conceded that the only method of assuring that the funds will be available when performance is called for is to insure the lives of the participating principals so that, at death, an instantaneous cash fund is generated. Of course, the shareholders could enter into, and possibly consummate, such an arrangement without the use of life insurance; but, if this were the case, there would always be doubt about their ability to raise the purchase price. This problem would be acute if the death of a principal ensued within a short time after the execution of an unfunded buy-sell agreement. Therefore, insurance is recommended as the funding vehicle; moreover, it is considered advisable to arrange for the insurance before the buy-sell agreement is actually executed, in order to permit the insertion of the appropriate provisions should it develop that one or more participants are uninsurable. To make certain that the survivors will have the funds on hand at the death of a stockholder, they agree to purchase and maintain a specified amount of insurance on each other. Note: A Means of Arriving at Value There is no one correct way to value a business, but any valuation should account for "good will" inherent in the going concern. In this sense "good will" can be equated to the concern's earning power. The Internal Revenue Service takes many factors into consideration when evaluating a business interest for estate tax purposes. Generally the IRS will accept any reasonable market value if it is set in a binding arm's length agreement. The following formula was used by the IRS (Rev. Rul. 68-609) and may serve as a guideline. The following illustrates the formula: Allow fair return of 8%1 of the average tangible net worth for last 5 years2 (capital + surplus) Average value of tangible net worth for net worth for last five  years .$25,000 Ascertain net earnings in excess of 8% of the average tangible net worth, and capitalize on a 5 year purchase basis to arrive at value of good will. Add this figure to tangible net worth to get overall value including good will Average net earnings for  last five years $150,000 8% of average tangible  net worth $2,000 Excess $148,000 Value of good will. (5x148,000) $740,000 Total value including good will $765,000 1Rev. Rul. 68-609 specifies 8% to 10% unless a prevailing percentage for the applicable industry is available. The 8% rate is applicable where the business is stable. The 10% rate is for high risk businesses. 2Five years is the minimum period.   CONSEQUENCES OF NOT HAVING A FIXED VALUE Failure to have a buy-sell agreement which establishes the value of your business for federal tax purposes may force your family to spend more than 6 years in court after you die. Such a procedure is also aggravating and expensive. This may nevertheless be the price for inaction now.   CORPORATE CROSS-PURCHASE BUY-SELL AGREEMENT  GLOSSARY 1. Purchaser Surviving stockholder(s). 2. Seller  Estate of deceased stockholder. 3. The Plan A contract between the stockholders requiring the purchase by the surviving stockholder(s) of all the stock of a deceased stockholder at a price fixed by the agreement, commonly called a "Cross-Purchase Buy-Sell Agreement". 4. Claims of Creditors Corporate creditors cannot reach proceeds of life insurance since it is owned by the stockholder(s). 5. Basis of Decedent's Stock to Remaining Stockholder Surviving stockholder(s) receive stepped-up basis for shares purchased from deceased stockholder. Subsequent lifetime sale will be calculated using value at time of sale as new basis. 6. Estate Tax Effects to Stockholder If sale of stock by estate of deceased stockholder is mandatory and price fixed in agreement is reasonable, the fixed price will set the value for federal estate tax survivors. 7.. Life Insurance Life Insurance proceeds are received by the surviving stockholder(s) Proceeds tax-free. 8. Effect on Value of The Corporate Stock The net worth of corporation is unaffected by receipt of the insurance proceeds by the surviving stockholder(s). 9. Family Corporation  Effect No problem with the rules of attribution under Sec. 318 when stock is purchased by the surviving stockholder(s). 10. To Change of Plan to Stock Redemption No transfer for value problem. Therefore, if in doubt, start with cross-purchase.   CORPORATE CROSS PURCHASE BUY-SELL AGREEMENT WHAT IT IS... A plan to effect the orderly change in the ownership of a close corporation at the death of a stockholder. A corporate cross purchase agreement works the same as a partnership cross purchase agreement. A Cross Purchase Buy and Sale Agreement: Creates a market for closely held stock Establishes a price for the stock Stockholders agree to buy the stock at death, retirement or disability Stockholders agree to sell their shares The Corporation can provide the money to fund the plan (purchase the insurance.)   HOW IT WORKS...