International Business Lawyer, Business Attorney, Fukuda Law Firm, San Francisco, California

Business Buy-Sell Agreements

Introduction
Buy-sell agreements are prepared by business attorneys for corporations, partnerships or LLC’s in order to provide for the orderly transfer of a business interest in the event of an owner’s death or withdrawal. A comprehensive buy-sell agreement should consider questions of taxation, corporate or partnership law, estate planning, insurance, and valuation, together with the requests of the owners and the needs of the business.

Purposes
Buy-sell agreements provide for the acquisition of the interest of a withdrawing shareholder, partner or member by the business entity or its remaining principals. The agreement often restricts the owners’ ability to transfer their shares, and it provides the terms under which the entity or other owners may or must acquire the interest of a shareholder or partner on death or other specified events. These agreements may benefit the entity and its owners as follows:

Prohibiting outsiders or heirs, whose interests may conflict with those of the remaining owners, from obtaining an ownership interest;

Assuring the continued legal existence of the entity on the death, withdrawal, bankruptcy, or expulsion of a partner;

Assuring continuity of management and control by the remaining owners; Expanding job stability for minority owners and key nonowner employees;

Orderly liquidation of the owners’ interests in the event of death, disability, retirement, or other forced or voluntary withdrawal;
         Terminating the continued involvement in the business of retired or inactive shareholders or partners;
         Creating a market for the shares of deceased, retiring, or withdrawing shareholders or partners;
            Providing cash to pay death taxes and estate settlement costs;
            Establishing the value of the interest, including a minority discount, for estate and gift tax purposes;
            Preventing the loss of an S corporation election by prohibiting transfer of the interest to an unqualified shareholder (e.g., a corporation) or to a shareholder who refuses to elect S corporation status.

The option or obligation to buy out a shareholder or partner is typically triggered by:

·Attempt to sell:
When a shareholder or a partner seeks to sell his or her interest in the business, the business entity will usually retain a right of first refusal on the same terms as the third party offer or at a price set in the buy-sell agreement.. If the entity is unable or elects not to purchase the interest, the other shareholders or partners may be given the option to purchase the interest pro rata.. On the other hand, the corporation or its board may obtain the power to designate another buyer or buyers. The seller may dispose of the interest to an outsider only if neither the entity nor the other shareholders or partners purchase the interest. Usually, the sale must be completed within a specified time and, if it is not, the rights of the entity and the other principals are renewed.

·Death:
The death of a shareholder or partner typically triggers the obligation to purchase the decedent’s interest by the entity or by the surviving shareholders

·Disability:
The disability of a previously active shareholder or partner may trigger a buyout. The agreement should clearly define “disability” and provide the method for establishing disability. Ordinarily, the buyout is triggered after a

·Expulsion or termination of employment:
A partner or a shareholder/employee’s voluntary termination of employment or expulsion from the business may trigger a buyout.·Bankruptcy: Bankruptcy or assignment for the benefit of creditors of a shareholder or

·Loss of license; death of licensee:
Loss of a professional license by a shareholder or partner of a professional corporation or partnership will trigger a mandatory buy-sell obligation in order to ensure continued compliance with professional corporation and licensing statutes. The death of a licensee or any other triggering event that may result in transfer of an interest to an unlicensed party should trigger a mandatory buy-sell obligation. For example, a law partnership is prohibited from continuing to practice law if one of the partners ceases to be licensed to practice law.·Attempt at dissolution: The agreement may also provide for buy-sell rights if the corporation is the subject of a voluntary or an involuntary dissolution attempt.

The agreement may provide for buyout of a shareholder’s interest in other events, such as a transfer of the interest to a creditor on a judgment or other legal process or to a spouse following a marital dissolution, or at any employment termination, whether involuntary or otherwise. Making the buyout optional rather than mandatory in any of the buy-sell events should be considered.

Permitted Transfers
            Certain transfers may be permitted by a buy-sell agreement. Gifts to immediate family members, especially those who are active in the business, or transfers to an inter vivos trust for the benefit of the immediate family, generally do not trigger an obligation or option to purchase. Such a transfer is ordinarily structured to ensure that the transferred interest remains subject to the buy-sell agreement. Transfers of interests in S corporations, however, must be restricted to eligible transferees.Price

Determination
One of the most important and critical tasks in planning a buyout is setting the price of the interest to be acquired. Although there are numerous uncertainties in valuing a closely held business, the parties must decide on a price. The price may be fixed and re-determined periodically or may be set by a formula or some other method. It may be advisable to provide for a price increase that is contingent on the sale of the business at a higher price within a specified time after the buyout occurs.

The attorney planning, drafting or reviewing a buy-sell agreement may face a problem ascertaining which party is being represented. The attorney may represent the entity itself, management as individuals, some or all of the shareholders or partners, or a combination of these parties. If the entity is the client, the attorney must ensure that he or she represents the organization itself, acting through its highest authorized officer, employee, body, or constituent overseeing the particular engagement. If it becomes apparent that the organization’s interests are or may be adverse to the organization’s directors, officers, employees, members, shareholders, or other constituents with whom the attorney is dealing, the attorney must identify the client for whom he or she is acting.

Counsel should take particular care in distinguishing between the entity and its constituents in order to avoid the risk of representing the entity inadequately or representing conflicting interests. For a small, closely held business, it may be desirable to have all the owners at every meeting to ensure accurate communication and expedite the process. This should eliminate the need to make continual changes to accommodate the views of those not present, and reduce the potential for actual or perceived bias. It may be desirable for the clients to formally authorize adoption of ground rules by the business entity.

Obtaining Complete Information
The initial decisions and actions concerning ethical and legal issues are based on the information presented by the client. There are many important background facts and legal distinctions that the client or prospective client may not understand or may even consciously fail to disclose unless questioned by the attorney.

Relative tax brackets, outside financial interests, and general personal and economic circumstances of each party should be considered. Some of the shareholders or partners may be cash-poor and need long payment terms to complete a cross-purchase. After obtaining complete information from all parties, counsel can ascertain whether actual or potential conflicts of interest exist and whether a suitable structure has been selected for the proposed venture. In-depth questioning of the clients on background facts ensures the decisions.

Checklist: Buy-Sell Procedures
The following checklist describes one approach to reviewing a client’s plans for his or her business interest focussing upon estate planning concerns.

1. Identify the client for whom the buy-sell agreement is drafted. If appropriate, advise other parties involved to seek independent legal representation. Counsel are often asked to represent the corporation and all shareholders, and care should be taken to identify and avoid possible conflicts of interest.

2. Counsel should review with the clients the various general approaches (e.g., a corporate purchase versus a cross-purchase by shareholders) and major alternative provisions. Tax objectives and consequences should be carefully considered from the outset.

3. Counsel should obtain and review the facts to determine what provisions in the buy-sell agreement would best suit the client’s needs. The following factors should be considered before drafting the agreement:
a. What events will trigger the buyout? Will they include the mere desire of a shareholder to sell? If so, must the shareholder produce a willing buyer?
b. For each event triggering a buyout (e.g., death, retirement) will the corporation or the remaining shareholders, or both, be the purchaser?
c. Will the buyout be mandatory on each such event, or will the selling shareholder have the option to sell and the purchasers the option to buy?
d. How will the purchase price be established? Will it vary depending on the reason for the buyout?
e. How will the buyout be funded, e.g., will life insurance provide all or part of the funding?
f. If life insurance will be used, are all shareholders insurable?
g. What method of payment will be used (e.g., cash or deferred payment)? If payment is to be deferred, at what interest rate and security? Will the parties require personal guaranties?
h. Must all shares offered by the selling shareholder be purchased or may fewer than all be purchased?
i. Will the agreement have a specified term?
j. Will any transfers (e.g., to family members or to certain trusts) be exempt from operation of the agreement?
k. Must the wills of any parties be modified?

4. Counsel should make sure that the buy-sell agreement has been submitted to all parties for review before its execution.

5. Counsel should ascertain whether there has been adequate disclosure of material inside information about the corporation (and, in unusual instances, about the individual shareholders) to all parties in order to comply with federal securities law. Distribution of financial statements and a written description of material inside information may be necessary. The larger the number and financial interests of shareholders outside the controlling group, the more careful counsel should be to ensure adequate disclosure of inside information. If the risk of insider liability is considered significant, counsel should prepare a written description of the corporation’s business, properties, and prospects and should attend a shareholders’ meeting to ensure that questions on the corporation and the proposed buy-sell agreement are properly answered. Questions and answers should be recorded in the minutes of the shareholders’ meeting.

6. The buy-sell agreement should be submitted to the board of directors for review before it is executed. Formal shareholder action is not ordinarily required at the time the agreement is executed.

7. If the buy-sell agreement is incorporated in an amendment to the articles or bylaws, and if the agreement materially and adversely affects any class of shareholders, an application for a permit under the California Corporations Code

8. When the buy-sell agreement is executed, counsel should supervise its execution and delivery. Spousal consent to the agreement may be desirable or necessary if the stock is community property.

9. A restrictive legend that refers to the buy-sell agreement should be placed on all outstanding share certificates representing shares subject to the agreement.

10. Wills or codicils, if required or desirable under the buy-sell agreement, should be prepared and executed by the individual shareholders.

11. If the effect of the buy-sell agreement is to create more than one class of stock, the California Corporations Code small offering exemption is not available.

Corporate Redemptioin vs. Shareholders' Cross-Purchase
Buy-sell or “buy-out” agreements for small, closely held corporations provide for the purchase of the shares of a withdrawing shareholder by either the corporation (an “entity purchase” or a “corporate redemption”) or the remaining shareholders (a “cross-purchase”).

Buy-sell agreements usually take the form of either a redemption, in which the corporation purchases its own shares from the selling shareholder, or a cross-purchase, in which the other shareholders purchase the seller’s interest. In the past, corporate purchases have generally been preferred to cross-purchases because of their simplicity and because corporate rather than personal funds or credit are used to complete the purchase.

The prime advantage of a corporate redemption is that it is simpler to administer than a cross-purchase because it involves only the corporation and the estate or withdrawing shareholder.

A major disadvantage of an entity purchase is the uncertainty about whether the purchase obligation will be enforceable when a triggering event occurs. A corporation is prohibited from redeeming its shares unless it can meet certain statutory financial tests which do not apply to cross-purchases.
A corporate redemption may also have significant unfavorable tax consequences, including:
(1) Recognition of income by the corporation if it distributes property to redeem the stock if the property’s fair market value exceeds its basis;
(2) Imposition of an accumulated earnings tax on funds accumulated beyond the reasonable needs of the business;
(3) Imposition of a corporate alternative minimum tax on the receipt of insurance proceeds;
(4) Recapture of investment tax credits and depreciation deductions if the corporation distributes appreciated property to redeem a shareholder’s interest; or
(5) Treatment of the redemption distribution as a dividend unless the distribution is substantially disproportionate, in complete termination of the selling shareholder’s interest, or not essentially equivalent to a dividend, taking into account the IRC attribution rules.

Cross-purchases have become more popular because of the potential adverse tax consequences of redemptions, particularly when insurance funding is used.

In addition to avoiding these adverse tax consequences, a cross-purchase agreement may benefit the remaining shareholders because they receive a basis in the purchased shares equal to their purchase price, which can be useful to an S corporation if there are losses that can be passed through to the shareholders.. With an entity purchase, the basis of the shares of the remaining shareholders is not affected, even though the value of those shares may be increased by the redemption.

A cross-purchase permits the relative power between groups of shareholders to remain the same by allowing them to structure the buyout so that the departing shareholder’s interest is purchased by members of the same group. In addition, if insurance funding is used, a cross-purchase is more equitable than a redemption when there are differences in the ages or shareholdings of the owners.

For most shareholders, the primary drawback of a cross-purchase is that they must use their own funds to finance the buyout. If the shareholders have to withdraw dividend income from the corporation to fund the buyout, the funds will be subject to double taxation: both as income to the corporation and also upon receipt by the shareholders. Another disadvantage of cross-purchase agreements is their increased complexity when insurance funding is used. In addition to the additional policies required, the shareholders must monitor the policies to ensure that no policies are allowed to lapse. Insurance proceeds may also be subject to taxation under the transfer-for-value rule.

Summary
Selecting the appropriate form and terms of the buyout requires consideration of numerous legal and tax factors in addition to the individual circumstances and goals of the parties to the agreement.