Co-owner planning with buy-sell

How a prior agreement can help protect your company against crises of ownership

Many times, business owners encounter unexpected and potentially traumatic situations that need planning. Co-owners may have irreconcilable differences, or face another owner's death, disability, resignation, retirement, divorce, bankruptcy, criminal act, or substance abuse.

Buy-sell agreements specify what happens, including buyers, terms of sale, and how the sale will be funded. They can also protect companies by addressing the risk of having to liquidate the business to pay the estate taxes due upon an owner's death, and restricting departing owners from entering a competing business for a period of time after leaving.

Advance planning avoids future problems. Without it, the business and its financial well-being may be in jeopardy. Everyone agrees on a plan under circumstances that are rational, fair, and non-adversarial, rather than in the middle of a crisis. Simultaneously, the basis for significant future tax savings can be put in place. A buy-sell agreement provides the following additional benefits:

* Planning for transition: The business will have predefined succession. This allows the business to continue normal operations when owners leave or retire.

* Financial security: The agreement assures that survivors will not lose the business to pay estate taxes.

* Corporate viability: Financing sources will appreciate the stability afforded by the existence of an agreement. They are likely to provide financing on terms that are more favorable.

* Retirement planning: Proceeds from a buy-sell agreement can fund owners' retirements.

* Estate planning: The agreement helps fix the value of the business in the estate of the deceased owner.

Business owners must obtain the assistance of legal and tax counsel in preparing the agreement. The following are key considerations.

Control ownership

Owners leave from time to time, both voluntarily and involuntarily. Equity interests should refer to the buy-sell agreement as governing their transfer. At a minimum, the agreement would grant other owners the option, as a right of first refusal, to purchase available interests.

The restriction prevents co-owners from selling shares to any old outsider who has the money. Similarly, at the death of a partner, you would not necessarily welcome the surviving spouse or children in his or her place.

Otherwise, allowing new owners might shift control, if voting rights transfer. They could obtain a voice in decisions, the right to access certain records, and standing to bring lawsuits. For example, under corporate law in the state of Illinois, two-thirds of stockholders must approve a merger with a stockholder, meaning anything over one-third can block it. Owners are also entitled to economic rights, such as dividends.

Determine purchase price

Usually, purchase price in a buy-sell is based on a valuation formula applied to the most current financial information. Valuation is particularly tricky, however, because tax law mandates that the price reflect an arm's length transaction. The concern is that owners might otherwise pass business interests to heirs at reduced values to avoid tax.

The value of a company consists of its assets and goodwill. The former can be measured with some certainty, whereas the latter is intangible. Goodwill is the agglomeration of characteristics that make the business more valuable than its assets alone. Fixing a dollar amount on goodwill is a subjective and difficult exercise for which you are advised to engage an expert. A thorough valuation helps assure that the price is adequately supported. Valuations draw on discounted cash flows, asset values, and market price multiples. They consider growth rate, projected expenses, working capital needs, expected capital expenditures, tax rate, and discount rate.

A key indicator of value is earnings before interest, taxes, depreciation, and amortization ("EBITDA"), where taxes refers to income taxes. It measures the cash flow that a business generates. Adjusted EBITDA is a widely used measure of estimated value. For closely held companies in general, the multiple of adjusted EBITDA to determine value is from four to six. For example, a company with adjusted EBITDA of $1 million is worth approximately $4 million to $6 million.

Valuations based upon EBITDA share the significant assumption that the purchase includes normal working capital, including accounts receivable, inventory and accounts payable, and equipment used in operations. Additional value would be derived from other items, such as investments and real estate. Bank and non-operating debt would be deducted in deriving the value of the equity interest.

A buy-sell provision might allow the party receiving a buyout offer the option to turn it into a purchase on the same terms. The idea is to keep parties honest in their offers. It might also include protection against co-owner fraud by making felonies a triggering event for sale to other owners at a reduced value.

Provide for funding

Having an agreement does not do much good if buyers cannot afford to go through with it. As valuations in- crease over tíme, so must funding, in order to provide for the cash needed to achieve the goal. Life insurance can cover the contingency of death, so that funds are there when needed, as long as the premiums are current. The level of insurance can vary with the change in value of the business from the valuation formula. As a practical matter to control costs, excess insurance coverage may be obtained initially to cover anticipated growth in the company's value over a multi-year timeframe.

For situations in which insurance does not apply or cannot be obtained at reasonable cost, buyouts can be funded by implementing a sinking fund in advance, or prospectively by installment payments with interest provided for at prime or other objectively determined rate. As long as the departing owner is owed money, the agreement can restrict payments to remaining owners, including caps on salaries and dividends.

In corporations, a retiring owner's tax on sale of stock is usually at favorable capital gains rates, or even lower in the case of qualifying small business stock. If done over a period of time, the installment method applies, under which the seller incurs tax on the gain ratably only upon receipt of cash. This may enable a higher share of the gain to be taxed at lower tax rate brackets in different tax years.

In Limited Liability Companies (LLCs) taxed as partnerships, on the other hand, exits are taxed as asset sales, which may reduce the portion of sales proceeds receiving beneficial capital gains treatment. Specifically, gains attributable to "hot" assets of accounts receivable and inventory are classified as ordinary. This is particularly onerous for cash-basis taxpayers, for whom the entire accounts receivable balance would be ordinary gain.

Payments characterized as compensation, LLC guaranteed payments, consulting fees, commissions, and payments under non-compete agreements are subject to ordinary tax rates, rather than capital gains. With the exception of non-compete payments, they are also assessed self-employment tax.

Special circumstances may enable objectives to be accomplished taxfree. For example, a company operating with divisions each separately run by an owner or distinct ownership team may be able to split them into separate companies, without the immediate exchange of cash.

Structure the transaction

The buyer can be the company itself or the remaining owners. The technical names for these structures are redemption and cross-purchase, respectively. Under the first structure, the insurance policies belong to the company. Upon an owner's death, his or her equity interest is redeemed and bought into treasury.

The proportionate ownership of the survivors remains constant. Some state laws require companies have sufficient equity capital to complete the redemption.

In a cross-purchase, on the other hand, each owner must carry insurance on each of the others, rather than a single policy per owner carried by the company.

For example, four owners must have twelve policies in total. Alternatively, insurance policies for cross-purchase may be placed in trusts or partnerships to circumvent these problems. An added advantage is that policies held outside the company avoid the risk of being business assets that are subject to the claims of business creditors.

The approaches are not mutually exclusive. Stockholders or members may be provided first rights to the ownership interest or defer to purchase by the corporation. That way, the choice of approach may adapt to changing circumstances.

There would seem to be a third option: for each owner to carry his or her own policy. While logical, it would be adverse from a tax standpoint. In an estate, the deceased's interest is automatically stepped up to its market value. If owned by the deceased, the life insurance proceeds at death might be included in the decedent's estate and subjected to estate tax, along with the value of the business. Even if distributed to other owners, marital or other deductions would not apply, such that the estate tax would be doubled up.

Avoid tax pitfalls

In the event of a buy-sell being triggered upon an owner's death, life insurance proceeds are generally tax-exempt to the beneficiary. The proceeds paid to the estate should equal the stepped-up value, so that no additional tax is incurred. However, there are many ways in which proceeds become taxable. Proper tax planning is critical in avoiding such situations.

In order to retain the tax-free nature of the proceeds, corporate beneficiaries under redemption plans must comply with section 101(j) of the Tax Code, which requires notice and consent documentation be obtained from the insured on tax form 8925. Also, proceeds received via redemption within a regular C corporation risk imposition of alternative minimum tax.

Moreover, if life insurance is used to fund corporate buy-sell agreements among stockholders via cross-purchase, proceeds from policies that are normally exempt from taxes for beneficiaries may be taxed at maximum rates under transfer of value rules. The clearest cases are those in which owners with policies on their own lives trade the beneficiary designation with the other owners, or survivors purchase the policies on the other surviving owners from a deceased owner's estate. A separate partnership might be preferred to avoid the issue.

The tax implications for survivors differ, often favoring a cross-purchase. A major consideration is step-up in basis, which represents a stockholder's cumulative investment as of a point in time. In C corporations, when survivors take direct possession of the stock under a cross-purchase, the basis of their interest increases by the amount of the purchase, whereas under stock redemption, no such advantage occurs. In S corporations, a different problem arises, in that tax-exempt income from life insurance proceeds must be allocated pro rata based on ownership share, including the deceased owner's estate. While a redemption provides a step-up, the estate's share is wasted, in that the full value of the business is already subjected to tax.

In an LLC taxed as a partnership, one strategy would be for the LLC to carry the policies and distribute life insurance proceeds to the surviving members, who would in turn purchase the deceased member's units and receive a stepped up tax basis. Unlike S corporations, LLCs can specially allocate the tax-exempt insurance income to the surviving members only, omitting the deceased's estate. With proper structuring, the tax-exempt income allocation fully covers the cash distributed to purchase the interests. EA

The value of a company consists of its assets and goodwill; die former can be measured with some certainty, whereas die latter is intangible

As long as the departing owner is owed money, the agreement can restrict payments to remaining owners, including caps on salaries and dividends

By William FL Wiersema, CPA, EA Contributing Editor