35 How to Arrange a Buy-Sell Agreement

35. How to Arrange a Buy-Sell Agreement in a Close Corporation In a closely held corporation, the death of one of the stockholders will often cause problems for both the deceased's family and the surviving stockholders. The deceased's estate will often find that the value of the business interest is much higher for estate tax purposes than expected and that a large tax is due. What's more, since the value of the business is the major part of the estate, there are no liquid funds with which to pay the tax. As for the surviving stockholders, they usually do not want the deceased's family to continue in the business (especially if the stock passes to an inexperienced relative). Both interests will be served with a buy-sell agreement funded with life insurance. A buy-sell agreement can also cover the retirement of an active stockholder rather than merely a buy-out at death. It may be agreed that, when a stockholder reaches retirement age, the corporation or the remaining stockholders will buy out his interest. Here, too, life insurance can provide the necessary funds. The same insurance policies that would have provided the proceeds with which to buy out the stockholder's stock should he die prematurely will have built up cash value that can be used should he live until retirement. The form of a buy-sell agreement in a closely held corporation will take the form of either a stock redemption agreement, with the corporation undertaking the obligation of redeeming the deceased stockholder's stock, or a cross-purchase agreement, in which each of the stockholders undertakes to buy a proportionate number of shares of the deceased stockholder's stock. Stock Redemption Agreement - In a stock redemption agreement the corporation agrees to buy the stock from the estate of a stockholder who dies (i.e., redeem the stock). There is a corresponding obligation on the part of the estate to sell the stock. If life insurance is used as the funding medium, the corporation should apply for the policy on the lives of the stockholders, have all incidents of ownership, pay the premiums, and be the beneficiary. The corporation uses the proceeds to buy the stock from the deceased stockholder's estate. If the insurance proceeds exceed the value of the stock for sale purposes, the excess is treated as key-man protection when payable to the corporation. The corporation gets no tax deduction for the premiums paid, but is not taxed on the proceeds. The corporation uses the proceeds to buy the deceased's stock. A variation on this arrangement is to allow the insured stockholder to name the beneficiary (usually a trustee) on condition that their stock be transferred to the corporation at death. The safest course to follow is to have the corporation assume the obligation to make the purchase of the stock and also own the insurance. Failing this and finding a situation that might result in a dividend to the survivors, check the situation against some cases that have taken a fairly liberal view on this score. Cross-Purchase Agreement - Under this arrangement, the stockholders take out and pay the premiums for insurance on the lives of the others in cross-ownership fashion. Each stockholder is usually designated the beneficiary of the insurance that he owns, and he is required by the agreement to use the proceeds to purchase the stock from the deceased's estate. Thus, in a three-way stockholder arrangement, each would own policies on the lives of the other two. A Vital Consideration When a stockholder dies, how will you handle the claims his heirs will make upon the business? Your interests will probably be quite different than theirs. They will want income. . .in healthy amounts like they received when the stockholder was alive, and somehow, if they're like most heirs, they will never seem to understand that most of what he brought home represented the work he did, not the stock he owned. Yet, if you're like most active stockholders in a growing corporation, you want the business to grow, fulfilling the promise of the future. The cash, dividend or income demands of the heirs, even though understandable, can become a crucial obstruction to that future, and they come at a time when the firm is adjusting financially to the loss of the dead stockholder's services. Perhaps the most tragic thing is that the heirs will be obstructing the business not because they want it to suffer or die, but because they want to live. The Crucial Obstructions Heirs Remain Stockholders The surviving stockholders carry the full load but are expected to share profits. Constant legal pressure can develop for unwarranted declarations of dividends, which would drain the firm's all-important working capital. If the heirs, needing additional income, become active in the business, the surviving stockholders discover that their lack of experience and basic aptitudes will handicap if not ruin the operation. Heirs Try to Sell to Outsider They may find it difficult. There may not be many people who know the business. . . Those who do may not have the money to buy. If they can buy, they may not make good associates. They may find it impossible to agree on a fair price because there is no open market for close corporation stock, and the heirs will again be thinking of the income they have to replace. Someone may be willing to buy at a high price, but why. . .to get a foothold in the business. . .to learn trade secrets. . .to eliminate competition? Heirs Sell to Surviving Stockholders They still want that unreasonable price because they still need the income. If an agreeable price is reached, the surviving stockholders have a choice of payment plans--they can pay cash by bleeding working capital and pledging additional capital, loading themselves with as much debt as they can carry, or they can eliminate any chance of a good profit picture for years to come by signing installment notes. Not a thrilling series of choices so far. Fortunately, there is one more alternative. . .but it is available only if acted upon before the stockholder dies. Your Plan of Action Enter into a legally binding cross purchase agreement with the other stockholders. When one dies, his estate must sell, and the survivors must buy his interest for a previously established price. Purchase sufficient business insurance on each stockholder's life by the other stockholders to provide the cash necessary to pick up the stock. This plan of action eliminates the crucial obstructions to the future success of the business, while at the same time making sure that the widows and children are treated fairly. It will place the value of each stockholder's interest for death tax purposes. It strengthens the credit line by guaranteeing to the creditors that their interests won't be compromised when a stockholder dies, and perhaps best of all, it gives the survivors full ownership and control of the business with no huge additional current or deferred debt load. The Cross Purchase Agreement When stockholders agree that those who live longer should take over the business with as few complications as possible, it's just good business to put everything down on paper in a legally binding agreement so that neither the surviving stockholders nor the heirs of the deceased stockholder are surprised or disappointed at a later date. A cross purchase agreement is drawn by the firm's attorney and usually mentions-- --that the estate will sell the deceased stockholder's interest to the surviving stockholders. --that the surviving stockholders will buy in proportion to their interest in the firm. --a method of establishing the selling price. (Usually set when the agreement is drawn and then periodically reviewed.) --that a stockholder cannot sell his stock while he is alive without first offering it to the other stockholders at the agreement price. --the purchase of sufficient business insurance by each stockholder on the lives of the others so that the cash needed to buy the stock will be there when it's needed. --other provisions to protect all stockholders and all heirs. These may include mention of alternate means of paying premiums, cessation of business, simultaneous death, mutual desire to discontinue the agreement, an adaptation to use a trustee, and, if so, the right to change trustees. The Stock Redemption Agreement When stockholders agree that those who live longer should take over the business with as few complications as possible, it is just good business to put everything down on paper in a legally binding agreement so that neither the surviving stockholders nor the heirs of the deceased stockholder are surprised or disappointed at a later date. If the stockholders also agree that their success has come through the activities of each stockholder, and that therefore the death of any one of them will cause a loss to the firm, a stock redemption agreement will be their best solution. It is drawn by the firm's attorney and usually mentions-- --that the estate will sell the deceased stockholder's interest to the corporation. --that the corporation will buy. --a method of establishing the selling price of the stock. (Usually set when the agreement is drawn, and then periodically revised.) --a method of payment. (All cash, or cash plus annual notes, or monthly income.) --that a stockholder cannot sell his stock while he is alive without first offering it to the corporation or to the other stockholders at the agreement price. --that the corporation will purchase business insurance on the life of each stockholder equal to the expected amount of loss it will suffer when each dies. (This is, in effect, key man insurance.) --other provisions to protect all stockholders and all heirs. These may include mention of cessation of business, simultaneous death, or mutual agreement to discontinue the agreement. Tax reference verification 1-800-829-1040 Back