Several columns ago, I considered certain aspects of succession planning and several reasons to consider entering into a buy/sell agreement. Since nearly 90% of all U.S. businesses are family owned or family controlled, and these businesses generate almost half of the U.S. Gross National Product, this type of planning is critical to future business success.
A buy/sell agreement is the cornerstone of successful planning for a business' future. So, let's now consider a few additional aspects of why to use a buy/sell agreement, the situation in which buy/sells typically arise and some of the key components of such agreements.
It is important to remember that buy/sell agreements are not only for corporate entities, whether Scorporations or Ccorporations for tax purposes, but for other entities as well, including limited liability companies and a variety of other business forms. While an Scorporation's buy/sell agreement should have the added benefit of helping to preserve the Scorporation tax status, the primary goals of buy/sell agreements are similar across business types.
Parties to a buy/sell seek to provide for long-term predictability of ownership in the business so that the business and its ownership interests continue in an agreed upon, orderly manner. The transfer of the ownership interests will be defined, at least generally, as to those who may hold such ownership interests and who may not and under what circumstances. By doing so, the market for such ownership interests upon the death of an owner (or the termination of a business entity owner) is more clearly known to the remaining owners and the ongoing business.
Obviously, establishing price is a key component of any buy/sell agreement. One key to pricing valuation is protection of both the majority owners, as well as minority owners. A minority interest may, for instance, in some circumstances, be appropriately discounted (and this may even be encouraged by the minority owners for certain purposes, such as for estate planning purposes). Clearly, tax considerations weigh heavily on such valuations, including possible discounts for minority interests. Likewise, the timing of distributions and the manner in which they are paid also play a significant role in the buy/sell planning.
Since one very likely scenario in which a buy/sell agreement comes into play is the death of an owner, estate planning considerations are paramount, and must be considered in tandem with the buy/sell provisions. For instance, the method by which the ownership interests are valued for estate planning purposes can be memorialized in the buy/sell agreement giving far greater confidence that such valuations pass muster with respect to any IRS review of the values placed on the ownership interest included in a decedent owner's estate. The key in this, as with all other terms of a buy/sell agreement, is to provide a reasonable "arms length" agreement among the owners as to the terms and restrictions of the transfer of ownership interests in a business.
Estate planning issues are also very important in respect to buy/sell planning for each owner whose primary, or at least significant, asset is his or her interest in a business. Providing for an orderly transition of ownership interests to parties acceptable to the remaining owners and with such liquidity as may be necessary for the overall estate of the decedent owner, is critical to his or her overall estate planning.
A buy/sell agreement is also important to the business itself. For instance, the buy/sell agreement will almost always provide for required transfers of an ownership interest upon certain events. The classic example is the bankruptcy, or some other type of insolvency, of an owner. The business must be protected so that the ownership interest is not subject to the bankruptcy estate, eventually leading to a new, and perhaps unwanted, owner in the business.
Likewise, particularly with respect to Scorporations, it protects the Scorporation status by limiting the avenues of the business having an unwanted, and perhaps legally untenable, owner. Likewise, such forced transfers avoid the otherwise private, closely-held business from being subjected to significant scrutiny in bankruptcy court involving one of its owners.
However, the buy/sell agreement goes into great length regarding the restrictions on the voluntary transfer of an ownership interest, as well-in other words, avoiding Aunty Mae becoming your new business partner. These restrictions may be based on family lines if a tightknit, multi-generational family is involved in the business or may simply provide for specific parameters within which the selling owner may sell his or her interest.
For instance, such restrictions may provide that the selling owner first provide a right of first refusal to the remaining owners or to the company (through a redemption of the ownership interest). While the law has generally frowned upon restrictions on the transferability of ownership interests, the law also acknowledges arms-length restrictions for reasonable business purposes. If for no other reason, the buy/sell agreement provides for such purposes and for such restrictions in a manner giving reasonable certainty to both the selling or deceased owner (and his or her heirs), as well as the remaining owners and the business itself.
In many cases, the ownership interest being sold will be tendered to the company in what is known as a "redemption." Such a feature is simple in that, if there is more than one remaining owner, it does not involve multiple purchases from the remaining owners, but rather the business is the single buyer. Whether or not a redemption is appropriate will depend upon a number of factors, many of which are tax driven.
For instance, whether a redemption has the appropriate balance sheet consequences for the business and whether it provides for a desired tax "basis" in the purchased stock, along with a variety of other tax and other corporate factors, will be determined by the particular circumstances of the business and its owners. With appropriate advice from legal, tax and accounting advisors, the appropriate structure of such a purchase should be easily determined.
As might be imagined, how to pay for any purchase is critical, whether by one or more remaining owner, an outside party (if a permitted purchaser) or by the company itself. One common structure worth noting here is the use of cross-purchase insurance. Cross-purchase provisions generally provide for remaining owners to purchase a selling owner's interest, with certain tax advantages attributed to such purchases (such as a step up in the tax basis in such interests).
In many cases, particularly with two-owner companies, for instance, insurance policies may be purchased on each other owner's life providing for appropriate liquidity to the remaining owner to purchase the interest. This also provides the added benefit of providing liquidity to the deceased owner's estate (and therefore his or her heirs).
In next month's column, I will consider several additional aspects of buy/sell arrangements and succession planning. In better understanding the potential of buy/sell arrangements, business owners can better ensure long-term certainty of a business' ongoing ownership and best provide for long-term personal, estate and business planning strategies in order to maximize value for all concerned.
Rich Drake is a Member of Womble Carlyle Sandridge & Rice, PLLC, practicing in the Corporate and Securities Group in Winston-Salem. Mr. Drake advises clients on practical approaches to achieve desired business outcomes in a variety of corporate, securities, financing and business technology matters.