Source: https://thismatter.com/money/tax/business-continuation-plans.htm
Timestamp: 2018-05-25 18:51:07
Document Index: 332393399

Matched Legal Cases: ['§2703', '§318', '§708', '§741', '§101', '§101', '§2703']

2018-01-12 A buy-sell agreement, also known as a business continuation agreement, is a legal contract providing for the disposition of a business interest when an owner dies, retires, becomes disabled, or withdraws from the business for some other reason specified as a triggering event in the agreement. The buy-sell agreement can be an entity plan, where an individual owner makes an agreement with the business itself, which is usually a corporation or partnership. With a corporation, the agreement is sometimes known as a corporate stock redemption agreement and with a partnership, a partnership liquidation agreement. There can also be an agreement between the individual owners to buy each other’s share of the interest, otherwise known as a cross-purchase agreement (a.k.a. crisscross agreement). The agreement can also be between an individual owner and some other individual outside of the business, or could be a key person or a family member. The buy-sell agreement can also be any combination of the above types of agreements.
The main purpose of a business continuation plan is to ensure that the existing stockholders maintain control of the company while at the same time providing fair value to the departing owner or heirs of a deceased or disabled owner. Otherwise, the heirs may sell to an outside investor who may not be agreeable to the existing stockholders. Or the heirs may interfere with the business or want to work in the business for a high salary, even if they lack the skills necessary to earn that salary. The proper continuation of the business is important to maintain its value. If a closely held business is shut down even for short time, a substantial amount of business may be lost in the meantime.
A primary concern should be whether the business can continue without the deceased owner. If not, then the business may have to be dissolved. The buy-sell agreement can also be contingent upon divorce of 1 of the business owners or their insolvency. Otherwise, an ex-spouse or a creditor could gain significant control of the business.
The buy-sell agreement helps to establish the value of the business interest for federal and state death tax purposes and allows the other owners of the business to continue the business without introducing unknown outsiders, especially if there is no family member of the departing owner who could replace the owner. Additionally, buy-sell agreements may be set up with another professional in the business since, under state law, some professional corporations can only have licensed professionals as key owners of the business.
Any business continuation plan must accommodate the heirs of the deceased owner and the surviving owners. Heirs of the deceased owner will want:
the highest price for their business interests, which will set the value of the business for federal and state estate tax purposes
prompt settlement of the estate; and
shielding the family from business problems and creditors of the business.
On the other hand, surviving owners want:
the lowest price for the decedent's interest
no interference from the decedent's family
prompt transfer of the business interest; and
a smooth transition of the business so that relationships with employees, customers, and creditors can be maintained.
A written agreement is the best way to ensure that the transition will be orderly.
The advantages of the buy-sell agreement include:
guarantees that the business interests will be purchased even if it does not pay dividends
establishes the value of the business interest for federal estate tax purposes that is binding on the IRS, if the rules of IRC §2703 are satisfied
specifies how the business interest will be purchased and is usually funded with life or disability insurance
provides the smooth transition for the business so that it can operate normally, thereby avoiding losses of any customers or employees and maintaining relationships with creditors.
A buy-sell agreement is a written agreement naming the parties to the agreement, the purchase price or a formula for determining the price, terms, and funding arrangements. The buy-sell agreement will also specify the event trigger that would create the obligations of the contract, such as death, disability, divorce, retirement, bankruptcy, felony conviction, or the loss of a professional license.
Because closely held businesses do not have market prices, other means must be used to value the business. There are 3 main business valuation techniques: a specified price; a price based on book value as reported in the company's financial statements; and formulas that account for net profits and, possibly, good will. Goodwill is the value of the business over and above the value of its assets. Much of this excess value comes from the location of the business, skills of the business employees, its customer list, the good reputation of the company.
The business or the business owners pay for the business interest by purchasing life or disability insurance on each owner. Premiums for life insurance or disability insurance are not deductible by the corporation, but the proceeds of the insurance will be tax-free, although it may be subject to the corporate alternative minimum tax (AMT). Likewise, the premiums paid by the corporation are not taxable to the shareholders.
Cross-Purchase Agreements
A cross-purchase buy-sell agreement is a written agreement among shareholders where each will purchase some shares of a deceased shareholder at a stated price, or a price set by formula, or through a price established by independent appraisers. A cross-purchase agreement usually requires that the shareholders of a closely held corporation buy life or disability insurance policies on each other’s lives, so that the proceeds can be used to purchase the stock of the decedent or disabled shareholder. Because the decedent shareholder has no incidents of ownership in the policy, the co-shareholder can receive the proceeds tax-free. Additionally, because a corporation is not involved in purchasing the stock, it will not be treated as a dividend by the IRS. Cross-purchase agreements stipulate that co-shareholders should have the 1st chance to buy the shares of the decedent shareholder, usually at a specified price or by using a formula.
With cross-purchase agreements, state insurance laws must stipulate that shareholders have an insurable interest on other shareholders, since life insurance cannot be purchased where the buyer has no insurable interest on the insured. Additionally, the premiums for each of the different shareholders will differ because of their age and other risk factors.
The premiums for life insurance or disability insurance are not deductible by the co-shareholders. But the death benefits will be tax-free and they will not be subject to corporate AMT. If the price paid for the stock exceeds the decedent stockholder’s basis, then the excess will be taxed as a capital gain.
A disadvantage of cross-purchase agreements is that each shareholder must have a policy on every other shareholder of the closely held corporation, with the number of policies = N × (N – 1), N = number of shareholders. So 3 shareholders would require the purchase of 3×2 = 6 policies. The number of policies that would be required will quickly increase with the number shareholders, as can be seen from using the formula for 4 shareholders: 4×3 = 12, double the number of policies for 3 shareholders.
When 1 of the stockholders dies, the estate will hold life insurance policies on each of the surviving stockholders under a cross-purchase agreement. Therefore, the surviving stockholders can buy the life insurance on their own lives from the estate without being affected by the transfer-for-value rule that would otherwise create taxable income to the extent that the life insurance proceeds exceed the amount paid for the insurance policy plus any additional premiums paid, because the exceptions to the transfer-for-value rule include transfers to the insured; to a corporation which the insured is either a stock holder or officer; to a partner of or partnership of the insured; when the new owner’s basis is based on the transferor's basis, or when the transfer of the policy is between spouses, including transfers required by a divorce decree.
A cross-purchase agreement can be changed to a stock redemption agreement in which the individual policies owned by the shareholders are transferred to the corporation without any income tax consequences, because it satisfies one of the exceptions to the transfer-for-value rule. However, converting a stock redemption plan to a cross-purchase agreement will trigger the transfer-for-value rule unless the policy is transferred is to the stockholder who is insured under that policy.
A cross-purchase plan is between the shareholders themselves; they get a new basis in the acquired stock which reduces taxable gain when the stock is later resold; the proceeds of life insurance policies are not available to creditors of the corporation, unless they can pierce the corporate veil; the shareholders must pay the premiums. If the corporation pays, then the payments will be considered additional compensation to the shareholders. The proceeds of the life insurance policies will not be available to the corporation, although the shareholders can lend the corporation the money.
Moreover, cross-purchase buy-sell agreements require that each of the shareholders maintain the life insurance policies. If any of the life insurance policies lapse because of nonpayment of premiums, then there may be insufficient funds to purchase the business interests of the decedent.
When there are numerous owners, a cross-purchase buy-sell agreement may not be desirable, considering the number of insurance policies that must be purchased. However, the problems of multiple life insurance policies can be reduced by using a trust deed buy-sell agreement where each owner signs an agreement with an independent trustee that allows the trustee to take out life insurance on each owner, where each owner contributes funds to pay the premiums for the policies. When 1 of the shareholders dies, then the trustee collects the insurance proceeds, transfers the proceeds to the estate of the decedent in exchange for the decedent's shares and issues new shares that are distributed to the surviving owners for the shares that belonged to the decedent. If a trust is not desired, then a corporate stock redemption plan is an alternative.
Most corporate continuation plans are stock redemption plans, where the corporation redeems the stock of the decedent, buying the shares from the decedent’s estate. The most common corporate continuation plans include the right of 1st refusal to existing stockholders or the corporation, where the stockholders agree to sell their stock to existing shareholders or the corporation at an agreed-upon price before they may be offered for sell to outsiders. The corporation could also have an option to buy a deceased shareholder’s shares, where the estate would be required to sell if the option is exercised, but there is no guarantee that the option will be exercised.
A stock redemption plan is where the corporation buys shares back from the deceased shareholder and usually finances the purchase with insurance carried on key employees or shareholders. However, the insurance proceeds are includable in income unless certain tax rules are followed, such as notifying each employee or shareholder that the corporation has purchased life insurance on their lives. A major benefit of the stock redemption plan is that the corporation only needs to buy 1 life insurance policy for each shareholder.
A stock redemption plan is between the corporation and the stockholders. The surviving stockholders own a larger share of the corporation, but the basis is unchanged. It is not stepped-up at the death of the decedent's stockholder. Additionally, state laws may only allow redemptions of stock from corporate surplus.
Under the constructive ownership of stock rules in IRC §318, a total redemption of the decedent’s stock may be treated as a taxable dividend. The corporation is a policy owner, beneficiary, and the premium payer. The corporation receives the proceeds of life insurance when a stockholder dies. A disadvantage to this arrangement is that cash values and the proceeds of the life insurance policies are available to creditors of the corporation.
A drawback of stock redemptions is that control of the corporation may change. For instance, if a parent and child own a majority stake in the business while an unrelated employee owns the rest, then if the parent dies, and the corporation redeems the stock, then the child may be left with a minority interest in the corporation.
The wait-and-see buy-sell agreement is one where the decision of whether to use stock redemption or a cross-purchase plan will be decided later, when the best decision becomes clear. A wait-and-see plan is a written agreement between stockholders and the corporation that gives the corporation the option to buy the stock. If the option is not exercised, then the shareholders may buy the stock. But if the shareholders do not buy the stock, then the corporation will be required to buy it.
There are 4 ways to fund a buy-sell agreement: cash, borrowing, installment payments, and insurance. Each has potential problems. With cash, will there be enough cash available to buy the interest? Will keeping the cash on hand incur opportunity costs where the funds could be used for greater return elsewhere? If the corporation accumulates the funds, will it be subject to the accumulated earnings tax?
To borrow money, the pertinent questions are at what interest rate, and will the surviving stockholders be able to borrow the amount needed to pay the interest to buy the decedent's interest. With installment payments, can the family afford to wait to receive their total interest in the business? What interest rate will they charge? Can the business of the surviving stockholders pay the amount required?
Because estate taxes are often paid with the proceeds of life insurance on key stockholders or employees, the pertinent question to ask is are they insurable? If any of them are married, does the non-active spouse have any rights, such as community property interests? The type of plan selected will also depend on the corporate tax bracket and on the individual employee or shareholder tax brackets, and on how many owners there are and their ownership percentage.
For uninsurable stockholders or employees, some companies will insure such individuals with special policies. One type of policy is a graded policy that provides a graded death benefit based on the amount of time the premiums are paid up, until the amount reaches the full death benefit. Another type policy will pay the full death benefit after a minimum time, such as 3 years. If death occurs before then, then the insurance company only returns the premiums with interest. If death occurs afterwards, then the full death benefit is paid.
Considerations for Specific Business Entities
There are some special considerations for specific types of business entities. A sole proprietorship can be temporarily continued by the executor or be closed or sold, or the business can be transferred to heirs. A sole proprietorship should be sold, unless the heirs have worked in the business and know how to manage it. Another possibility is if the sole proprietorship has a key employee who knows the business well enough to continue it. In such cases, a buy-sell agreement can be established between the business owner and the key employee to continue the business after the owner's death. This will also help them to retain the employee and motivate the employee to work harder, since the business will eventually be his.
Limited liability companies with 2 or more members that is operated as a partnership, will, without a business continuation agreement, be forced to dissolve when 1 of the members dies. The surviving members become liquidation trustees where the law requires them to dissolve and terminate the business.
If the corporation is an S corporation, then any subsequent sale of stock must be restricted to maintain the S corporation status. For instance, S corporation shares cannot be sold to foreigners nor can the number shareholders exceed 100. Moreover, if an heir receives more than 50% of the voting shares of the stock of the S corporation, then the heir may revoke the S corporation status, which may not be desired by the other shareholders.
Business Continuation for Partnerships
A partnership requires a continuation agreement to survive the death of 1 of the partners; otherwise, it is legally dissolved. In most cases, a buy-sell agreement will be between the partnership and the decedent's partners estate, where the partnership agrees to buy the interest of the deceased partner or it could be a cross-purchase plan where the surviving partners purchase the deceased or withdrawing partner's interest.
Under IRC §708, if more than 50% of the total partnership capital and profits are sold within a 12-month period, then the partnership is considered dissolved. However, if only the interest of the partners is liquidated rather than sold, then there is no dissolution.
The sale of a partnership interest to other partners or a third-party, such as an employee, will be realized as a capital gain or loss except to the extent that the partnership has hot assets, defined under IRC §741 as unrealized receivables and inventory, since these items are not treated as capital assets in any case.
If a partner's interest has been liquidated because he died, then the basis of the partners interest in the partnership, referred to as the inside basis, gets stepped-up to its current market value.
If the partners buy whole life insurance on each of the partners under a cross-purchase plan, then the policies can be transferred between the partnership and the partners without the transfer being subject to the transfer-for-value rule under IRC §101(k)(2)(B). The rule also applies to LLCs taxed as partnerships. However, for the life insurance proceeds to be tax-free, the partners must be notified that a life insurance policy has been taken out on them. Otherwise the proceeds will be taxed under IRC §101(J).
Special Rules for Family Businesses
Artificial restrictions of property that were imposed to devalue the property for tax purposes will be ineffective if a sale is for less than market prices. IRC §2703 stipulates that any restrictions on the sale or use of property are disregarded in valuing the property unless they meet these 3 tests: they are bona fide business arrangements; there is no transfer of property to the decedent's family or natural objects of the decedent's bounty for less than full and adequate consideration; and the terms of the agreement would be acceptable to unrelated people at arm's-length transaction's. 4 factors are considered in assessing whether the 3 tests are met: the present fair market value of the property; it's expected value on the date of exercise of rights under the agreement; the adequacy of the consideration offered for the option or agreement; and the expected terms of the agreement.
If the business owners reside in a community property state, then the agreement should account for any ownership interest that the surviving spouse may have in the business.