This is the first of a two-part article on buy-sell agreements. The second part will be featured in the June TaxStringer.

Most accountants are familiar with the concept of Buy-Sell Agreements, and after practicing long enough, most accountants are involved in planning several Buy-Sell Agreements and administering at least a few of them. Buy-Sell Agreements create the mechanism for an entity and its owners to experience an orderly transition of equity ownership and governance upon a wide range of events that might include death, disability, retirement, voluntary withdrawal, or an impasse among the owners.

In our experience, most professionals will ruin at least one aspect of the planning or execution of a Buy-Sell Agreement; what goes wrong is usually not a product of incompetence, but rather the lack of awareness that buy-sell planning requires integration of a broad range of disciplines and advisors. Consider the list of trusted professionals that would be working together on an ideal business succession team:

• The Tax Accountant is typically the longest-tenured, most trusted advisor for the business; the tax accountant knows both financial and qualitative details about the business itself and the owners. The tax accountant is often the first to notify the owners about the need for buy-sell planning.

   

• The Forensic Accountant values the business to guide the insurance planning and the legal drafting involved in setting up a Buy-Sell Agreement. As many accountants know, owners are often biased when gauging the value of their own businesses, so they are frequently shocked to read a valuation professional’s report about the estimated fair market value (FMV) of their equity.

   

• The Insurance Professional prescribes the policies of life and disability insurance necessary to ensure the Buy-Sell Agreement is actually funded. The legal and accounting framework of the Buy-Sell Agreement would be useless without the capital to help the parties fulfill their obligations, and insurance is the best way to secure that capital.

   

• The Wealth Manager understands an owner’s financial situation and how the owner should structure a transition to provide for herself and her family in case of either a planned or unexpected triggering event under the Buy-Sell Agreement.

   

• The Corporate Attorney typically takes the lead in drafting the Buy-Sell Agreement because of how heavily the process emphasizes contract law and corporate governance. If the corporate attorney is serving an “outside general counsel” role for a closely held business, she also plays a key role in ensuring a smooth transition when the agreement swings into action.

   

• The Trusts & Estates Attorney advises about how the Buy-Sell Agreement will serve as part of the owner’s estate plan and ensures both the buy-sell planning and the estate planning are properly interwoven with each other. If those two plans do not synergize well, both will suffer when put into action.

   

• The Tax Attorney advises about how income, estate, and gift taxes might impact all parties. Both income and transfer taxes are often equally important to the owners involved. Incorrect structuring could spell financial disaster for both the business and its principals.

   

• The Business Broker or Investment Banker assists with an exit when the current owner desires an exit involving a third party; when the strategy is to sell or merge, the best approach is to enlist this person to market the business and seek out the right counterparty.

   

• The Business Banker assists when any type of bank financing might be necessary to enact the buy-sell plan. When brought in as part of the planning team, the banker can advise about how much financing might be available to the business when one of the triggering events occurs. The amount, conditions, and nature of the financing might differ depending on which triggering event has happened.

And this list only enumerates the advisors involved in a proper buy-sell plan; others who would be part of the process might include the owners’ family members, the key employees of the entity, and other potential stakeholders. A business owner’s (and an accountant’s) first reaction to seeing this list of participants and angles to cover might be, “Gee, that sounds like an expensive proposition.” Our response to this concern is that drawing up a proper plan is actually the least expensive option. The more expensive paths are the potential consequences of doing nothing, which could include:

• Failure of the business if the triggering event is unexpected; even temporary failure could result in direct financial losses, sacrifice of market share, or departure of critical personnel.
• An impasse among the owners, which could lead to total cessation of operations. Chaos typically ensues when uncertainty exists about the purchase price of a departing owner’s equity, the fulfillment of the departing owner’s role, and the governance structure to deployed in the departing owner’s wake.
• Adverse tax consequences, which could financially cripple either the business or its equity holders; at minimum, they could greatly decrease the owner or her family extracting maximum benefit out of the business she may have invested a lifetime in building.

This primer introduces accountants – even those experienced with buy-sell planning – to the tax and non-tax angles involved in a complete buy-sell plan.

Tax Considerations in Buy-Sell Planning

In any buy-sell plan, tax will be an important factor in choosing the right option. Regardless of circumstances, a variety of tax issues could influence which path owners could choose for their business.

When selling to a third party, owners sometimes get to negotiate how to allocate the sale price between different “buckets” of items. One bucket is the allocation of purchase price between the assets themselves, including intangibles such as goodwill; in this bucket, the tax professionals need to carefully consider asset character, recapture, and potential mitigation strategies at the entity or individual level. A second bucket is a potential ongoing consulting or employment arrangement after the transaction is complete; this is typically the least tax-advantageous category because of the imposition or ordinary income and payroll taxes, but it could be helpful to build up further Social Security or retirement plan contributions. A third bucket is a covenant not to compete, which at least avoids payroll tax. A fourth bucket could be the sale or leaseback of the real estate used in the entity’s trade or business. Sales might trigger recapture, but tax consequences could be completely deferred through Sections 1031 or 1400Z-2; leasebacks allow the owner to derive further income from the property, but net rent is taxed at ordinary rates unless the income tax basis is sufficient to produce offsetting depreciation deductions.

The Basic Estate and Gift Tax Consequences of Business Succession

In a sale to a third party, valuation and control issues are fully and finally settled through arm’s length negotiation. The sales proceeds inure to the owner and become includible in her gross estate unless she undertakes other planning beforehand. In any buy-sell scenario not involving a third party, the income tax part is usually easy (a straight sale of equity), but the valuation and control issues – including for purposes of the federal estate tax – are not simple at all.

When valuing an interest in any business that makes up less than 100% of the issued and outstanding equity, a large estate and gift tax advantage for the asset class is the availability of valuation discounts.[6] The lower the percentage interest and degree of control afforded the interest, the higher the discounts can be. This is why recapitalizations are popular ahead of business succession planning;[7] they allow for owners to retain the voting equity to run the business unilaterally while transferring capital value out of the taxable estate. In the family business context, however, more nuanced tax considerations may apply.

In a bona fide operating family business, the specter of Section 2036 is usually not a serious threat because the entity has a legitimate non-tax purpose for existing; contrast this outcome with Family Limited Partnerships motivated primarily by estate and gift tax concerns, which have come under increasing government challenge in recent decades.[8] Instead, in the buy-sell context, the primary concern becomes Section 2703.

Enacted as part of Chapter 14 of Subtitle B in the early 1990s, Section 2703 is designed to prevent family buy-sell planning from customizing the value of a business interest for estate tax purposes. Whenever a business is held exclusively by members of one family, Section 2703 will always be a concern; in a nutshell, the statute holds that any pricing in a buy-sell agreement between family members must fulfill a difficult safe harbor requiring arm’s-length comparables to pass muster for estate tax purposes. Consider an example in which Amber and Barbara own equal interests in an operating business. Their Buy-Sell Agreement fixes a $1,000,000 purchase price for either one-half interest in the event of the other’s death. If Amber and Barbara are related for Section 2703 purposes, the statute disregards the fixed purchase price when determining fair market value (FMV) of the interest for purposes of the decedent’s taxable estate (unless the arrangement meets Section 2703’s difficult safe harbor). If they are not related, however, Section 2703 does not apply, and the purchase price almost certainly controls for estate tax purposes – even if the purchase price is below FMV.

After striking a Buy-Sell Agreement, which might include a recapitalization, business owners could choose to transfer equity by gift, sale, bargain sale, or bequeathal. Gifts of equity come with a carry-over basis,[9] and tax partnerships tabulate capital account consequences under Section 704(e). Sales achieve Section 1012 cost basis for the buyer and Section 1001 treatment for the seller. Bargain sales combine the two treatments as appropriate. Bequeathals come with estate inclusion, and planners must grapple with the ever-evolving state of the unified credit;[10] on the other hand, all bequeathed equity receives a Section 1014 basis adjustment, which is a potentially huge boon for the recipients. When weighing which of these options is best, the advisory team must balance these tax concerns with a litany of financial and qualitative factors, which is one of the many reasons buy-sell and business succession planning is more art than science.

Any buy-sell owner as a result of an unexpected occurrence. In order to successfully exit the business, the owner must address both valuation and control issues. Ideally, the business tackles these early in its life cycle and revisits them on an intermittent but relatively frequent basis.

A chosen exit strategy depends on the facts and circumstances available. If there is a ready third-party purchaser, an owner can simply sell her equity to a third-party purchaser; but if there is no ready third-party purchaser, or the governing documents of the company prevent a sale to a third party, the owner can make a voluntary exit in one of four ways: (i) selling her equity to one or more existing owners; (ii) selling her equity to the company; (iii) gifting the equity to a family member; or (iv) shutting down and closing out the business.

While the many facets of selling all part of a business to an outside acquirer are beyond the scope of this article, the business succession aspects of this strategy are important and risk being overlooked if practitioners are not careful. Often, the professionals are so caught up in the basics – including price, method of payment, and particulars of the owners’ continued involvement in the business (if any) – that they overlook the peripheral but equally impactful aspects of the transaction. These might include the tax ramifications of certain purchase price allocations, as described above; how key employees might regard the sale, and whether any major departures would impact the company’s ability to achieve an earnout; and whether the acquirer needs to secure insurance shielding against the death or disability of the former owner.

Selling In: Acquisition by the Company or its Insiders

This option is where the other equity holders or the entity itself buys back the equity held by the exiting owner. If the equity holders purchase, the purchasers enjoy concentrated equity and a Section 1012 cost basis for the new interests. If the entity purchases, however, the remaining owners are concentrated proportionately, which could shift the balance of voting power.[11] An entity purchase also denies any basis adjustment to the remaining owners. These tax disadvantages are why we prefer structuring cross-purchase arrangements to entity purchase arrangements in most instances, despite the moderate administrative inconvenience of the former.

Gifting and Bargain Sales

This option is generally used in a family business with the goal of keeping the business in the family and ensuring competent successor management. Any transfer of ownership would be subject to any provisions in the bylaws or governing agreement, a particularly important aspect as the generations go by; as successors become related with greater degrees of consanguinity, the risk for an impasse usually becomes greater.

If the owner transfers ownership to one or more family members while he or she is still alive (an inter vivos transfer), such owner will need to file IRS Form 709 if part or all of the transfer is a taxable gift. This presents the option of paying any gift tax due at the time of the transfer or reducing the unified credit; unless the value of the transferred interest is greater than the taxpayer’s available lifetime exemption, the transfer may be free from gift taxes. With the use of lifetime exemption, however, comes a concomitant reduction in the available estate tax exemption that can be applied to the assets bequeathed at death.

Grantor trusts present a method for owners to extract liquidity from some or all equity in the business while seizing gift and estate tax advantages.[12] Grantor trusts come in several flavors and can be used alongside gifts or sales of equity, extensions of loans, use of Section 2702 grantor retained annuity trusts (GRATs),[13] and use of Section 2701 “freeze” partnerships. Grantor trusts are useful because of their tax flexibility and asset protection features; rather than gifting or selling interests to family members outright, which could leave the equity exposed to creditors, a transfer in trust allows the beneficiary to be a Co-Trustee with broad management powers while carefully employing independent Co-Trustees to control the timing, destination, and purpose of distributions.

Another subtle but important advantage of transferring assets during life is the certainty of tax treatment. With the rapid pace of tax law changes in the modern era, including a built-in sunset of the Section 2010(c) credit in the Tax Cuts and Jobs Act,[14] one cannot reliably predict the legal climate at the time of one’s death unless she is experiencing most unfortunate circumstances.[15] Planners must weigh this distinct advantage against sacrificing the Section 1014 basis adjustment for assets bequeathed at death.

Liquidation is a viable option, primarily for small businesses that are dependent on the performance of a single individual. The advantage of this option is in its simplicity. However, this option presents the lowest return on investment because the only money from a liquidation sale is from the disposal of assets, the proceeds of which are subject to creditor claims. In tax corporations, a liquidation is considered an exchange of corporate stock for corporate assets, a transaction potentially taxable at both the corporate and shareholder levels (even in Subchapter S corporations);[16] therefore, shutting down is often disadvantageous from both a financial and a tax perspective. In lieu of liquidating, owners should consider a so-called “one-way” buy-sell, which we discuss in Part II.

Joshua P. Friedlander is the founder of ArisGarde, a wealth advisory and insurance structuring firm. Joshua advises on financial, estate, and business planning matters for families and corporations across various industries including construction, healthcare, staffing, real estate and the clients of law and accounting firms. He focuses on insurance designs and investment strategies to be integrated as part of business succession and executive retention for business owners and their key employees.

Matthew E. Rappaport, Esq., LLM, is vice managing partner of Falcon Rappaport & Berkman PLLC (FRB). and he chairs its Taxation and Private Client Groups. He concentrates his practice in taxation as it relates to real estate, closely held businesses, private equity funds, and trusts & estates. He is licensed to practice in New York and is an active member of the American Bar Association Section of Taxation, where he serves on the Sales, Exchanges, and Basis committee. FRB extends its thanks to Joseph A. Stackhouse, Esq., LL.M. for his assistance in researching and drafting this article.

Daniel J. Gershman, JD, is a Law Clerk – Admission Pending – in the Corporate & Securities Practice Group of Falcon Rappaport & Berkman PLLC (FRB).  Daniel will focus his practice on domestic and cross-border corporate and securities law matters and related tax issues.  He also works closely with FRB’s Taxation and Private Client Groups assisting with structuring and compliance matters involving closely held businesses, real estate and trusts & estates.