Drafting Buy Sell Agreements
A “buy-sell agreement” (“BSA”) is an agreement between a business entity and/or its owners setting forth restrictions on an owner’s ability to sell her interest during life and prescribing the terms under which the interest is sold on death. It may also include provisions for disability of an owner. A BSA is the key document in business succession planning and is also a crucial document for estate planning of the owners. Where the entity involved is a limited liability company (“LLC”), the terms of a BSA are included in a document called an operating agreement. Where the entity involved is a partnership, the document is called a partnership agreement.
The focus of a BSA is on income, loss, control of entity, equity ownership and defining buyouts in the event an owner desires to sell during life and mandating a sale in the event of death.
The corporation’s capital structure and organizational documents are found in the certificate of incorporation and its by-laws. Control of the corporation is made by shareholders voting for a board of directors who are involved in major decision making for the corporation. The board of directors also votes for the officers of the corporation who are in charge of the day to day affairs of the corporation. A major reason behind a BSA is that owners typically do not want persons who happen to inherit stock to be involved in the operation or management of the business.
BSAs can take three forms: redemption by the corporation, cross-purchase by the acquiring shareholders or a hybrid of the two.
In a redemption, it is the corporation who purchases the available stock. In a cross-purchase agreement, it is the other shareholders who purchase the available stock. In a hybrid agreement, the corporation is given the first option to purchase the shares, then the shareholders have the option to purchase the shares.
The question of which of the three types of BSA depends on factors such as the number of shareholders and the type and complexity of funding. Cross-purchase agreements are often preferable as they provide the purchasing shareholders tax basis in the shares equal to the consideration paid. When there are many shareholders, a redemption is easier to implement especially when insurance is being used.
The price for the sale can be based upon a number of different methodologies: They can be based upon an agreed upon value typically adjusted by agreement of the shareholders every two years, or by appraisal to be performed upon the event of sale. Otherwise, the price can be by formula such as adjusted book value, a multiple of net or gross income, or a combination of book value and multiple of income.
One consideration in drafting a BSA is whether to make the purchase of shares mandatory or optional. Typically, if a shareholder desires to sell shares or is ousted, the corporation and the other shareholders will have a first option to buy the shares. If the corporation does not exercise its option to buy the shares, the other shareholders are generally allowed to purchase the stock pro rata. On death of a shareholder, though, the estate of the deceased shareholder is typically obligated to sell in accordance with the terms of the BSA.
Often times the owners are also employees of the company. Purchase of shares upon termination of employment is often preferred. There are four types of termination: voluntary, retirement, involuntary for cause and involuntary without cause. A definition of “for cause” will always be included in the agreement. The purchase price and terms of payment will often depend on the type of termination.
Tax considerations. Corporations are either: (1) S Corporations – those companies that have properly elected to be taxed as an S corporation; and (2) C Corporations – all corporations that have not elected S status. For S corporations, the BSA will need to have a prohibition against a shareholder selling to an entity that would be an ineligible transferee that would cause the termination of the S Status. Transfers that would cause the corporation to have too many shareholders or to an ineligible trust or person will be prohibited under the BSA.
Estate tax considerations. The IRS has the right to challenge BSAs as not being bona fide arms-length market prices and the IRS is generally not bound by the price set forth in the BSA in determining whether the deceased shareholder is responsible for estate tax.
Income tax considerations. In situations where the value of the stock is higher than its tax basis, it is generally preferred to utilize a cross-purchase rather than redemption for tax purposes for the basis step up available. The seller generally receives capital gains treatment and if payment is made over more than one year, the seller may report tax on the installment method. Currently, the tax on dividends and capital gains are the same.
Insurance funding. Many companies choose to fund their obligations under a BSA with insurance on the lives of the shareholders. BSAs often require the company to use the insurance proceeds received on the death of a shareholder as payment in full or as a down payment for the purchase. If the insurance has cash value, the cash value of the policy can also fund the purchase of the shares on the retirement or disability of a shareholder. If the company is the owner of the life insurance policies, the requirements of Code Sec. 101(j) must be followed to assure that the proceeds are exempt from income taxation.
Endorsements on Certificates. There should be endorsements on stock certificates. The stock certificates should bear a legend on the stock certificates stating that the stock is subject to the BSA.
NEW FILING REQUIREMENTS DUE TO ESTATE TAX REPEAL Due to what some are referring to as Congressional malpractice, the estate tax and generation-skipping transfer tax (GST) do not apply for estates of decedents dying in 2010 and thus, there is no requirement to file an estate tax return or a GST tax return for such an estate. However, other filing requirements continue to apply, and a new filing requirement is imposed to reflect the modified carryover basis rules that apply to property acquired from a decedent dying in 2010.
By way of background, the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”)increased the unified credit exemption amount in steps from $1,000,000 to $3,500,000 by 2009 and then repealed the estate tax for decedents dying in 2010. While EGTRRA eliminated the estate tax and GST tax decedents dying in 2010, EGTRRA did not repeal the gift tax for gifts made during 2010, although it did reduce the top gift tax rate to 35% from 45% for gifts made in 2010. Also, EGTTRA repealed the GST tax on direct skips, taxable terminations, or taxable distributions occurring in 2010.
Since EGTRRA was a budget bill based upon a 10 year budget in 2000, its provisions expire or “sunset” after 2010. Therefore, the estate tax, GST and gift tax will return in full force in 2011 unless Congress acts at the rates they were in prior to the enactment of EGTTRA with a $1,000,000 exemption for estate and gift tax and $1 million with an inflation adjustment for the GST. The maximum rate for estate, gift, and GST tax return to their old levels of 55%, with a surtax for estate and gift transfers over $10,000,000.
What filing requirements exist: Since the gift tax was not repealed, Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, must still be filed for gifts in 2010.
With the repeal of the estate and GST tax came a new carryover basis rule for 2010. Under the carryover basis rule, the basis of assets acquired from a decedent is the lesser of the decedent’s adjusted basis (carryover basis) or the fair market value of the property on the date of the decedent’s death with certain exceptions. The exceptions are:
1. The executor can allocate up to $1,300,000 to increase the basis of assets; and
2. The executor can also allocate up to $3 million, to increase the basis of assets passing to a surviving spouse, either outright or through a qualified terminable interest property (QTIP) trust.
These allocations are to be made by the executor on a tax return required by Code Sec. 6018 and Code Sec. 1022(d)(3)(A) ) The I.R.S. is working on the form which will be due on April 15, 2011. However, the form has yet to be created and will be found at www.irs.gov when it is finally created. Also, no later than 30 days after the filing of this soon to be created form, the return must also be issued to the estate’s beneficiaries.
The return must be filed with the final income tax return for the decedent. The repeal of the estate and GST tax has no effect on the requirement of filing the Decedent’s final income tax return (Form 1040) and fiduciary income tax returns (Form 1041) for the estate during each year of estate administration.
Dollar Limits for Most Retirement Plans Unchanged from 2010 to 2011Based on annual cost-of-living adjustments (COLAs) for retirement plans the IRS has announced the 2011 limits related to pension and other retirement plans. Most are unchanged while others rose slightly.
The following limits remain unchanged effective for 2011:
Defined benefit plans. The limitation on the annual benefit under a defined benefit plan under Code §415(b)(1)(A) is $195,000.
Defined contribution plans. The limit on the annual additions to a participant’s defined contribution account under Code §415(c)(1)(A) is $49,000.
Annual compensation limit. The maximum amount of annual compensation that can be taken into account for various qualified plan purposes, including Code §401(a)(17) , §404(l) , §408(k)(3)(C) , and §408(k)(6)(D)(ii) is $245,000.
Elective deferrals. The Code §402(g)(1) limit on the exclusion for elective deferrals described in Code §402(g)(3) is $16,500.
Deferred compensation plans. The limit on deferrals under Code §457(e)(15) concerning deferred compensation plans of state and local governments and tax-exempt organizations, is $16,500.
SEP plans. The compensation limit under Code §408(k)(2)(C) (amount of compensation above which an employee who meets other requirements must be able to participate in the employer’s SEP plan) is $550.
SIMPLE accounts. The maximum amount of compensation an employee may elect to defer under Code §408(p)(2)(E) for a SIMPLE plan is $11,500.
Catch-up contributions. The dollar limit under Code §414(v)(2)(B)(i) for catch-up contributions to an applicable employer plan other than a plan described in Code §401(k)(11) or Code §408(p) for individuals aged 50 or over is $5,500. The dollar limit under Code §414(v)(2)(B)(ii) for catch-up contributions to an applicable employer plan described in Code §401(k)(11) or §408(p) for individuals aged 50 or over is $2,500.
Key employee in top-heavy plan. The dollar limit under Code §416(i)(1)(A)(i) relating to the definition of key employee in a top-heavy plan is $160,000.
ESOP five-year distribution period. The dollar amount under Code §409(o)(1)(C)(ii) for determining the maximum account balance in an employee stock ownership plan (ESOP) subject to a five-year distribution period is $985,000, while the dollar amount used to determine the lengthening of the five-year distribution period is $195,000.
Highly compensated employee. The dollar limit used in defining a highly compensated employee under Code §414(q)(1)(B) is $110,000.
Government plans. The annual compensation limitation under Code §401(a)(17) for eligible participants in certain governmental plans that, under the plan as in effect on July 1, 1993 allowed COLAs to the plan’s compensation limit under Code §401(a)(17) to be taken into account, is $360,000.
Control employee. The employee compensation amounts used in the definition of “control employee” for purposes of the auto commuting rule of Reg. §1.61-21(f)(5)(i) is $95,000; and the compensation amount under Reg. §1.61-21(f)(5)(iii) is $195,000.
The following plan limits calculated by reference to Code §1(f)(3) are increased:
Excess employee compensation for purposes of determining installment acceleration amounts. The Code §430(c)(7)(D)(i)(II) limit used to determine excess employee compensation for single-employer defined benefit plans for which the special election under Code §430(c)(2)(D) has been made is increased from $1,000,000 to $1,014,000.
IRA income limits. The 2011 figures reported by IRS for the income limits used to determine traditional IRA deductions are as follows:
An IRA is deductible for joint filers with modified adjusted gross income (MAGI) under $90,000 and ratably phased out up to $110,000 (up from $89,000 and $109,000 respectively)
For single taxpayers and heads of household, the numbers are unchanged at $56,000 and $66,000 respectively. For married filing separately, the numbers are unchanged at $0 and $10,000 respectively.
Finally for married taxpayer who is not an active participant in a plan but whose spouse is, the phase out numbers increase to $169,000 and $179,000 up from $167,000 and $177,000.
Roth income limits are up slightly: Joint filers phase out $169,000 to $179,000 up from $167,000 and $177,000 respectively. For single taxpayers and heads of household, the numbers are $107,000 and $122,000 up from $105,000 and $120,000. For married filing separately, the numbers are unchanged at $0 and $10,000 respectively.