Business Buy and Sale Agreements

It is incumbent upon the principal shareholders of a closely held corporation to 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 (or at a retirement).

This page 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.

1. The inadvisability of a decedent's heirs retaining an interest in a closely held corporation which, in the usual case, will not produce income especially dividend income for them, due to the "double taxation" of any dividends. Dividends are paid after tax by a corporation. And regular wages will no longer be paid out following the death of their husband or father.

2. 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.

3. The surviving shareholders, on the other hand, in the absence of a planned disposition of the stock at the death of a stockholder, might be faced with potentially dissident outside shareholders - i.e., the heirs of a deceased shareholder or even the heirs' representatives.

In order to avoid these complications, and to assure that the surviving shareholders (the ones who will continue to 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 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 corporation enter into a buy-sell contract with all the principals. The contract will provide that, upon the death of a shareholder, the corporation shall be bound to purchase, and the decedent's estate shall be bound to sell, the decedent's stock.

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 corporation could enter into an arrangement without the use of life insurance; but, if this were the case, there would always be doubt about the ability of the corporation to raise or borrow 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. Trying to borrow money to buy out the stock of a key person to a business who just died could be difficult. The business just lost one of its key people and needs money to spend on a non-income producing purchase, the stock. Depending on the circumstances this may be impossible to do. And if it is possible the business will have to pay back the loan plus interest resulting in a possible long term costly obligation to the business who has already suffered the loss of a key person. (See the page on funding alternatives for more details on this and the other options, click here)

If the agreement is funded out of cash flow from the corporation, the family of deceased is left dealing with business on a long term basis. The surviving family's future income is dependent on the success of business. It would be better for the surviving family to receive the full value of the stock at the owner's premature death and be out of the business. Not to mention the business is saddled with a long term non-income producing financial obligation at the time it has just lost a key person.

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 corporation will have the funds on hand at the death of a stockholder, the corporation agrees to purchase and maintain a specified amount of insurance on each stockholder. The event that causes the need also creates the cash to take care of the need.

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.

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.

1. Purchaser	The Corporation
2. Seller	Estate of deceased stockholder
3. The Plan	A contract between the corporation and the stockholders requiring the purchase by the corporation of all the stock of a deceased stockholder at a price fixed by the agreement, commonly called a "Stock Redemption Buy-Sell Agreement".
4. Claims of Creditors	Corporate creditors can usually claim against proceeds and cash values of corporate-owned life insurance, but not personal creditors.
5. Basis of Decedent's Stock to Remaining Stockholders	Surviving stockholders do not receive stepped up basis since corporation is the purchaser of stock. Value of stock is enhanced but the income tax basis is not increased. Their lifetime sale of their stock after a redemption may result in more taxable gain to them.
6. Estate Tax Effects	If sale of stock by estate of deceased is mandatory and the price fixed in agreement is reasonable, the fixed price will set the value for federal estate tax purposes. Life insurance proceeds are received by the corporation tax-free.* Difference between cash value and proceeds increases value of stock on corporate balance sheet.
7. Family Corporation	When stock owned by related persons where the beneficiary of an estate owns stock, redemption may result in unfavorable tax results to the estate through rules of attribution under I.R.C. 318.
8. To Change Plan to Cross Purchase	Transfer for value problem, i.e., proceeds in excess of premiums are taxable income.
* Under the 1986 Tax Act cash values and death benefit of corporate owned policies are tax preference items which must be taken into account in computing alternative minimum tax.

The contemplated arrangement is a buy-sell contract calling for a complete stock redemption at the death of the respective shareholders under Section 302(b)(3) of the Internal Revenue Code of 1954. It is believed that the proposal arrangement will fully comply with this Section, and accordingly the redemption will not, in whole or in part, be construed as essentially equivalent to a dividend and taxable to the estate of a deceased shareholder as ordinary income. Furthermore, if surviving shareholders are not close members of the deceased shareholder's family or beneficiaries of his estate it appears that there will be no problem relative to the attribution rules embodied in Section 318 of the Internal Revenue Code. Thus, the distribution by the corporation in complete redemption of all the stock of a deceased shareholder will be considered the purchase price paid for the stock and not the distribution of a dividend.

It is understood that the principals are concerned both about fixing a value for their stock interests for Federal Estate Tax purposes, and are concerned with the problem of the orderly continuity of the corporation while assuring that their respective families will receive the full value of their business interest.

A buy-sell contract if properly drafted, will fix a definite or predictable Federal Estate Tax value, and avoid the dangers inherent in the valuation of a closely held business interest - i.e., it will convert a non-liquid business asset into cash, while at the same time, fix the value for estate tax purposes. In this connection, Rev. Rul. 54-76, 1954-1 C.B. 194: Rev. Rul. 59-60, 1959-1, C.B. 237, Sec. 8, may be reviewed.

Where the corporation itself is to purchase the stock of a deceased shareholder, it should own the policies, pay all premiums, and be the beneficiary for the proceeds. If this is the case, the premiums that the corporation pays will not constitute income to the shareholders. This is the rule now established by the Casale, Prunier, Sanders and Doran cases, and Rev. Rul. 59-184.

At the death of a shareholder, the receipt, by the corporation, of the insurance proceeds will not constitute taxable income to the corporation, I.R.C. Sec. 101(a)(1).*

*Under the 1986 Tax Act cash values and death benefits of corporate owned policies are tax preference items which must be taken into account in computing alternative minimum tax.

This penalty tax is imposed when a corporation, in order to prevent profits from being taxed to its shareholders retains earnings not needed in the business. To complete the amount of income subject to the tax, a credit of $250,000 ($150,000 for professional corporations) is allowed for accumulations to meet reasonable current and anticipated business needs. Therefore, the tax should not be imposed upon income net aimed for the purchase of life insurance if the insurance serves a valid business purpose and is related in type and amount to that need. General Smelting Co., 4TC 313.

The United States Court of Appeals interpreted the predecessor to Section 531 - 1939 I.R.C. Section 102 - in Emeloid Co., Inc. v. Comm'r., 189 F. 2d 230 (1951). In that case the corporation had entered into a stock retirement agreement with its two principals, using a single premium insurance contract and a substantial amount of new insurance to implement the agreement. The corporation, however, had borrowed to purchase the single premium policies and had taken a "borrowed capital credit" in computing its excess profits tax (basically the same as the accumulated earnings tax). The issue, therefore, was whether the insurance was acquired for reasons that were personal to the individual shareholders, or whether it was for a proper corporate business reason. The court's opinion, in favor of the corporation, bears consideration as persuasive authority:

(The stock retirement agreement was to provide) a further business objective viz., to provide for continuity of harmonious management. Harmony is the essential catalyst for achieving good management; and good management is the sine qua non of long term business success. (The corporation), deeming its management sound and harmonious, conceived of the (stock retirement plan) to insure its continuation. (The corporation) apparently anticipated that, should one of its key stockholder-officers die, those beneficially interested in his estate might enter into active participation in corporate affairs and possibly introduce an element of friction. Or his estate, not being bound by contract to sell the stock to (the corporation), might sell it to adverse interests. The fragile part of a small business can be wrecked on just such uncharted shoals.

The particular policy suggested in this proposal is composed of two elements, cash value and pure insurance. The cash value represents the current value of the investment -- as such, it is carried in an asset account on the balance sheet. Since surplus is not diminished by the portion of the premium attributed to cash value, the actual insurance expense for a fiscal period is the difference between the amount of the premium payment and the increase in the cash value for that period.

Upon the death of the insured and payment of the proceeds, the asset value of the insurance equals the face amount of the proceeds. Thus, a recognition of an increase is surplus, represented by the difference between the insurance proceeds and the cash value, is appropriate. For purposes of explaining the nature of the "insurance investment" a footnote comment on the balance sheet as to the nature of the indemnity insured against is generally recommended. This may take on added significance where an explanation for accumulated earnings is called for, particularly with reference to I.R.C. Sec. 531.

CORPORATE STOCK REDEMPTION

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.

It solves the problem of:

Creating a market for closely held stock for the surviving family
Establishing a price at which the corporation agrees to buy and the stockholders agree to sell their shares
Providing the money to fund the plan

The Corporation:

Enters into an agreement with the stockholders
Purchases, owns and pays the premiums on each stockholder
Is named beneficiary of each life insurance contract