Buy Sell Agreements
If you own an interest in a family-owned or other closely held business, a buy-sell agreement should be a key component of your estate plan. These agreements specify whether — and under what circumstances — owners’ interests may be transferred, ensuring that the business stays in the family and meeting other important estate and succession planning goals.
Buy-sell agreements should be planned and drafted carefully to ensure that they meet your expectations and don’t trigger unwanted tax consequences or intrafamily conflicts.
A well-crafted buy-sell agreement provides many benefits, including:
Typically, buy-sell agreements achieve these objectives by requiring or permitting the company or the remaining owners to purchase the interest of an owner who dies, becomes disabled or leaves the business. They may also provide the company or the remaining owners with a right of first refusal in the event an owner wishes to sell his or her interest.
Generally, buy-sell agreements are structured either as “redemption” agreements or “cross-purchase” agreements. The former permit or require the company to purchase a departing owner’s shares, while the latter confer that right or obligation on the remaining owners.
From a tax perspective, cross-purchase agreements are generally preferable. The remaining owners receive the equivalent of a “stepped-up basis” in the purchased shares, in that their basis for those shares will be determined by the price paid, which is the current fair market value. Having the higher basis will reduce their capital gains if they sell their interests down the road. Also, if the remaining owners fund the purchase with life insurance, the insurance proceeds are generally tax-free.
Redemption agreements, on the other hand, may trigger a variety of unwanted tax consequences, including corporate alternative minimum tax, accumulated earnings tax or treatment of the purchase price as a taxable dividend.
The disadvantage of a cross-purchase agreement is that the owners, rather than the company, are responsible for funding the purchase of a departing owner’s interest. And if they use life insurance as a funding source, each owner will need to maintain insurance policies on the life of each of the other shareholders, a potentially cumbersome and expensive arrangement.
A buy-sell agreement’s valuation provision is critical to avoiding unpleasant surprises or conflicts. Generally, the fairest and most effective method of setting the purchase price is to conduct periodic independent business valuations and to base the price on fair market value.
Many agreements set the price using a formula tied to earnings, cash flow, book value or some other objective measure. Although formulas offer simplicity and lower costs, they can’t account for subjective characteristics or other factors that drive business value. As a result, they often underestimate or overestimate business value, which can lead to disputes when the buy-sell agreement is invoked.
When putting together a buy-sell agreement, it’s important to define your terms carefully and to consider the potential implications of the agreement’s language. A recent California Court of Appeal case — Saccani v. Saccani — illustrates how the language of a buy-sell agreement can lead to intrafamily conflict years or even decades later.
In that case, Albert Saccani had died, leaving his three sons — Donald, Roland and Gary — as equal shareholders of the family business. In 1991, the sons entered into a shareholders’ agreement that, among other things, gave the company a right of first refusal in the event a shareholder wished to sell or otherwise dispose of his shares in a manner other than a “permitted transfer,” as defined by the agreement. Permitted transfers included transfers by the shareholders 1) to one another, 2) to their respective descendants, and 3) to estate planning trusts for their respective descendants.
Donald, who had no children, transferred his shares to a revocable trust that gave Gary an option to purchase the shares after Donald’s death. Donald died in 2007, and in 2012 Gary exercised the option, acquiring a two-thirds interest in the company. In 2013, Roland died, leaving his one-third interest to his two sons. Roland’s sons sued, claiming that the option granted to Gary wasn’t a permitted transfer and, therefore, violated the shareholders’ agreement. Rather, they argued, the company should have been afforded its right of first refusal, which, if exercised, would have given them a 50% interest in the company.
The court disagreed, finding that the option was a permitted transfer. The court noted that the term “transfer” was broadly defined as “gift, sell, pledge, encumber, hypothecate, assign or otherwise dispose of,” which encompassed the option Donald had granted to Gary.
Before signing a buy-sell agreement, test it to see how it’ll perform under various scenarios and choose your words carefully to ensure that it fulfills your objectives. In Saccani, for example, if Albert had intended for the business to be owned equally by his sons’ families, he could have included specific language designed to achieve that result.
The terms “buy-sell agreement” and “shareholders’ agreement” are often used interchangeably. But in fact, a shareholders’ agreement refers to a broader category of which a buy-sell agreement is a subset.
A buy-sell agreement deals specifically with the disposition of shares of a shareholder who dies, becomes disabled, or wishes to sell his or her ownership interest. Shareholders’ agreements typically include buy-sell provisions, but may also include noncompetition, nonsolicitation and confidentiality restrictions; voting procedures; dispute resolution mechanisms; and other provisions related to corporate governance or shareholder
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