Editor's Note: This is the first of a two part article. The concluding part will appear next month and will include tax considerations and estate freeze limitations.

Owners of closely-held businesses are often advised to adopt a "Buy/Sell Agreement." This article explores the basic attributes of Buy/Sell Agreements. Why would a business owner want to adopt a Buy/Sell Agreement, and what effect would a Buy/Sell Agreement have on the owner and his business?

Definition

A Buy/Sell Agreement is essentially an agreement among the owners of a business to allocate control, by means of cross purchase and sale obligations in the event of the agreement or the death or disability of one of the principals.

Objectives of a Buy/Sell Agreement

A properly drafted Buy/Sell Agreement should achieve both the business and personal planning objectives of the owners. The primary business objective of a Buy/Sell Agreement is to provide for the continuing control of the business by one or more of the owners and to set a price for the buyout of the others. This can be important to the owners of a closely-held business in a variety of circumstances. For example, if one owner dies and his interest in the business is inherited by his spouse, the other owners may find that the spouse's interest in the business is adverse to their interests. Because of cash flow concerns, the spouse may favor the distribution of all business profits and refuse to contribute additional equity to the business when the other owners favor expansion. The spouse may lack knowledge of operations and may not be willing to assume liability in the borrowings of the business. The other owners may find their ability to continue the business significantly impaired.

Apart from a situation resulting from the death of an owner, the management of a business may want to prevent continued ownership by a person discharged from employment by the business, or to prevent ownership by a person who would want to change existing management, or a person whose ownership might threaten certain tax advantages.

The primary estate planning objectives of a Buy/Sell Agreement are to provide a mechanism to assure some liquidity for an owner's estate (or for the owner, upon his termination or retirement from employment), and to fix a value for the owner's business interest for estate tax purposes. When the substantial portion of an owner's estate is comprised of his interest in a closely-held business, it may be difficult for his estate to raise the cash necessary to satisfy estate tax liability and other administrative expenses. A Buy/Sell Agreement that requires all or part of the owner's interest to be purchased from his estate upon death can ensure liquidity. The owner can also ensure that the price payable for his business interest is fair and adequate by being directly involved in the price negotiation, rather than leaving the task to the executor or beneficiaries who may not be as familiar with the business.

Under certain circumstances, the price set forth in the Buy/Sell Agreement may be used to establish the estate tax value of the owner's interest in the business. Consideration must be given to the effects of recent estate tax law changes discussed at the end of this article. In the absence of a Buy/Sell Agreement, the IRS will often undertake an independent determination of the value of a closely-held business. Under these circumstances, the IRS may ask to review all of the business records to analyze earnings capacity, book value, dividend-paying capacity, goodwill, the economic outlook of the business and the industry, etc. Thus, the use of a qualified Buy/Sell Agreement may avoid costly appraisals and valuation disputes between the owner's estate and the IRS.

Effect of Buy/Sell Agreement on Owner's Interest

As a result of entering into a Buy/Sell Agreement, each owner of the business would be obligated to sell his interest in the business at a specified price upon the occurrence of certain triggering events. The price payable for an owner's interest in the business may be a fixed dollar amount or may be determined by reference to a variety of factors. For example, the price might be determined by reference to an independent appraisal, bona fide third party offers, book value, net earnings, multiples of book value or net earnings, capitalization of earnings, or some combination of these. The owners may determine that the price should be fixed for the entire term of the Buy/Sell Agreement, or the price may be subject to redetermination on an annual basis or, for example, at specified yearly intervals. It is also good to have different price determinations apply in the case of different triggering events.

In order to ensure that the Buy/Sell Agreement will fix the estate tax value of the business, the triggering events must include the owner's death and any attempt to sell an ownership interest during the owner's life. Other triggering events used in the typical Buy/Sell Agreement include the owner's retirement, disability or termination of employment.

The Buy/Sell Agreement will also identify who will be obligated or entitled to purchase the owner's interest upon the occurrence of a triggering event. If the owners are each obliged or entitled to purchase the selling owner's interest individually, such an agreement is commonly referred to as an "Owner Cross-Purchase Agreement." If the owners agree that the business entity (i.e., the corporation or partnership) will purchase or retire the selling owner's interest, such an agreement is commonly referred to as an "Entity Redemption Agreement." The purchasing obligation may also be mixed, as between the owners and the business, such that the business entity has a right of first refusal which, if not exercised, will cause the other owners to be obliged (or to have option) to repurchase or retire the interest. Such an agreement is referred to as a "Mixed Agreement."

When the owners, (rather than the business entity) will be obligated or entitled to purchase the interest of a selling owner, either under an Owner Cross-Purchase Agreement or a Mixed Agreement, the owners must determine a method for allocating the purchase obligation or option. The most common method of allocation is by reference to the relative percentage ownership interests of the remaining owners. The purchase obligation or option may also be allocated on the basis of seniority, capital contributions, profit participation, etc. The Buy/Sell Agreement should also contain a provision for the situation where one owner cannot or does not wish to participate in the purchase, so that the remaining owners could step in and assume that owner's purchase obligation or option.

Financing the Buy-Out

Unless the owners have sufficient cash flow themselves to finance the purchase of an owner's interest, the purchase will normally be funded with earnings from the business, or with insurance proceeds.

If the purchase is funded from the earnings of the business, the owners will have to take into account the tax cost. As a general rule, cash distributions from an S Corporation or a partnership may be made to the owners on a tax-free basis. Thus, either an Entity Redemption Agreement or an Owner Cross-Purchase Agreement may be used and funded with the earnings from the business without any additional tax cost to the owners. If, however, the funds will be available only from a corporation, the owners may be in receipt of taxable dividend income upon the distribution of corporate funds to finance a purchase obligation under an Owner Cross-Purchase Agreement. Thus, if the business is operated in C Corporation form and the funds required to finance the buy-out will be available only from the corporation, an Entity Redemption Agreement may be more tax efficient. Apart from the tax costs, businesses operated in corporate form (including S Corporations) may be limited by local law restrictions on the amount of capital which may be used to purchase an owner's interest pursuant to an Entity Redemption Agreement. Under such circumstances, a Mixed Agreement may be more appropriate so that the corporation would redeem the shareholder's interest to the extent allowable by local corporate law, and the owners would assume the remaining purchase obligation.

Assuming the purchaser's available cash flow is insufficient or cannot be adequately projected, the purchase of an owner's interest on his death might be funded by life insurance. Under these circumstances, the person obliged to purchase an owner's interest (i.e., the owners or the business entity) would acquire life insurance policies payable upon the death of each owner and would be responsible for paying the insurance premiums on the policies. As the owner and beneficiary under the policies, the purchaser would not be entitled to deduct the premium payments, but the insurance proceeds which would be used to fund the purchase obligation under the Buy/Sell Agreement could be received by the purchaser on a tax-free basis.

When a Buy/Sell Agreement is funded by insurance, there are distinct advantages to using an Entity Redemption Agreement rather than an Owner Cross-Purchase Agreement. The primary advantage of the Entity Redemption Agreement is that the entity needs to purchase only one policy for each owner. In the case of an Owner Cross-Purchase Agreement, each owner would be required to purchase a policy on the life of every other owner. Thus, with several owners, the number of policies required may be substantial.

With an Entity Redemption Agreement, each owner bears the cost of insurance in relation to their ownership interests. The owners can also ensure that premium payments will be made on a timely basis since the premiums are all paid by the business entity. With an Owner Cross- Purchase Agreement, younger owners (with a lesser ownership interest) may pay the full cost of the older owners' more costly insurance. In addition, as discussed above, if the premium payments will be funded with earnings from a C Corporation business, the owners run the risk of receiving taxable dividend income. Also, with an Owner Cross-Purchase Agreement, the obligation to make premium payments is left to the individual owners. If one of the owners allows a policy to lapse, the other owners may have increased financial commitments under the Buy/Sell Agreement, or it may not be fully enforceable.

Although the proceeds from an insurance policy are normally received on a tax-free basis, when an insurance policy is acquired for "value," the proceeds payable on the death of the insured are taxable to the extent they exceed the cost of the policy. If in a business, operated in corporate form, using an Owner Cross-Purchase Agreement, one owner dies and if the other owners succeed to or purchase the deceased owner's policies on their lives, the insurance proceeds ultimately paid from those policies could be taxable under the "transfer for value" doctrine. In the case of an Entity Redemption Agreement, no transfer for value problem would arise as a consequence of the death of an owner. In addition, in the case of a business operated in corporate form (including an S Corporation), with an Entity Redemption Agreement, an owner can transfer or sell an existing policy to the corporation without causing insurance proceeds to be taxable under the transfer for value rule. In the case of an Owner Cross-Purchase Agreement, however, the sale of an existing policy to other shareholders would cause the insurance proceeds to be taxable under the transfer for value rule.

An initial purchase of the policy directly from the insurance company would not be subject to income tax as a purchase for value.

There are also some disadvantages in using an Entity Redemption Agreement funded with insurance. Creditors of the business may be able to reach the insurance policies as assets of the business debtor. In addition, in the case of a C Corporation (but not an S Corporation), a new alternative minimum tax preference item, referred to as the "book income" adjustment, could require the inclusion of the insurance proceeds for purposes of the alternative minimum tax calculation.

Terms of Payment

The Buy/Sell Agreement will set forth the terms of payment to the selling owner or his estate. Payment could be required in a lump sum or on an installment basis, or a combination thereof. The terms of payment might differ with each triggering event. For example, if the Buy/Sell Agreement is funded in part with life insurance, payment might be made in a lump sum upon the triggering event of death, but in the form of installments on the triggering event of retirement. Installment payments offer the selling owner the advantage of deferring tax liability from the sale under the installment sale method of tax accounting. However, installment payments will be required to bear adequate interest, or interest may be imputed.