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Agreements
BY JULIE BOGLE, JD
Buy-Sell
Buy-sell agreements are commonly used in closely held businesses to provide certainty in retirement and succession planning, a ready market for otherwise unmarketable ownership interests, and to prevent undesirable changes in ownership. Simply put, they are contracts between the owners of a business that fix owners’ rights with respect to one another and with respect to the business. Under a typical buy-sell agreement, certain events (death, disability, or termination of employment, for example) will trigger a right or a requirement on the part of an owner or the owner’s estate to sell his or her ownership interests. Concurrently, either the company or the other owners of the company are required or are given the right to buy the departing owner’s interests. There are two main types of buy-sell agreements: redemption agreements and cross-purchase agreements. A redemption agreement typically either requires or gives the company the right to buy the departing owner’s interests. A cross-purchase agreement typically either requires or gives other owners the right to buy the departing owner’s interests.
Which type of buy-sell agreement should you use?
The primary nontax considerations when choosing which type of buy-sell agreement to implement are funding and security in arranging the buy-out. In a cross-purchase agreement, the remaining owner(s) must either finance the purchase or receive insurance proceeds that will fund the purchase of ownership interests from the departing owner. The departing owner may have doubts about the remaining owners’ ability to secure the buy-out debt or make the required payments. In a redemption agreement, the company either obtains the financing for the buy-out or receives insurance proceeds used to fund the buy-out. Another important non-tax consideration in choosing an agreement is ownership after the transfer. If there will be more than one owner remaining after the transfer, a cross-purchase agreement that does not require a proportionate buyout by the remaining owners may change the relative ownership interests, resulting in a formerly minority owner becoming a majority owner, and vice versa. Contemplated changes such as these should often be negotiated well in advance of the triggering event to ensure the company survives the transfer. The tax considerations in deciding whether to choose a cross-purchase or a redemption agreement can be complicated – not only for the departing owner, but for the remaining owners and the company.
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Madison Sun Prairie Columbus 608.836.7500 www.sgcpa.com
Cross-purchase agreements nearly always result in the departing owner recognizing capital gain or loss. He or she will recognize gain to the extent proceeds received in the sale exceed his or her adjusted basis in the ownership interest. The company is generally unaffected by the ownership transfer. After a cross-purchase buyout, the remaining owners’ basis in their interests increases by the amount they have paid for the departing owners’ interests. This may be very beneficial where the company is an S corporation generating losses, since shareholders can deduct those losses on their personal tax returns only to the extent they have basis. Under a redemption agreement, in contrast, those shareholders’ bases would not increase following the transfer. With a redemption, the departing owner may receive capital gain treatment upon redemption of his or her interests, but the agreement must be carefully drafted to ensure this result. If the interest being redeemed is that of a C corporation and if the departing owner’s redemption does not qualify for capital gain treatment, amounts paid to him or her will be treated as dividends to the extent the corporation has earnings and profits, and then as a return of capital. Although under the 2003 Tax Act both dividends and capital gains are taxed at 15%, that rate is scheduled to sunset at the end of 2008. If a redemption buy-sell agreement could include a redemption in 2009 or later, then securing capital gain treatment will be crucial to avoid redemption payments being taxed at ordinary income rates. Additionally, even though the dividend treatment may not apply if the entity is an S corporation, qualification for capital gain treatment is still important because it will affect the tax consequences of future distributions to the remaining shareholders.
Julie Bogle is head of the High Net Worth Individual service specialty and a manager in the tax department of Smith & Gesteland. She concentrates on proactive planning for individuals, including income tax planning, estate planning and business succession. She also works extensively in tax planning related to divorce, owner compensation, and incentive compensation planning.
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