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For educational purposes only. Not for use with the general public.

Business Entities: Buy-Sell Analysis and Opportunities

A Continuing Professional Education Course

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The information in this presentation is designed to be general in nature and for educational purposes only. Guardian, its agents and employees do not give tax or legal advice. For specific advice, seek and rely upon the advice of a qualified tax advisor or attorney.

GEAR # 2010-10624 Expires: May 31, 2012

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Every businessregardless of its revenue, assets

or number of owners − should have a

Business Succession Plan!

Who Needs a Buy-Sell Agreement?

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Who Will Keep or Buy An Interest In A Closely Held Business?

• Partner or Co-Shareholder

• The Business Entity itself

• Key Employee

• Third Party (i.e., competitor, vendor, etc.)

• Family Member

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What is a Buy Sell Agreement?

• Business Owner’s “Will”

• Sale Triggered by Death, Disability, Retirement and Other Events

• Purchase of Appropriate Interest byBusiness, Remaining Owners, Key Persons or Family Members

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The Need for a Buy-Sell Agreement

• Provides liquidity for taxes and expenses

• Prompt payment

• Sets fair and reasonable price

• Determines the value of a deceased shareholder’s interest for Federal Estate Tax purposes

• As little conflict as possible

Advantages to the Deceased’s Estate

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The Need for a Buy-Sell Agreement

• Provides money to help meet ongoing expenses

• Converts business wealth to personal wealth to pay for retirement

• Prompt payment

• Sets fair and reasonable price

• As little conflict as possible

Advantages to the Departing Owner

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Advantages to Surviving Owners

• As little conflict as possible

• Prompt exit of deceased’s heirs

• Continuity of management

• Stability for employees, vendors and clients

• Establishes a fair and reasonable price

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Triggering Events

• Death• Disability• Retirement• Loss of Professional License• Others

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Client’s Children in the Business

• What are plans for succession?• What about those not active?• Family block

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Client’s Children in the Business

• Buy-sell agreement• Wealth transfer strategies

– Installment sale to intentionally defective grantor trust

– Grantor retained annuity trusts– Family limited liability companies– Family limited partnerships

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Other Potential Buyers

• Vendors• Competitors• Key employees

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Key Employees

• If not buyers: – What happens to them under new

management?– Employment contracts ?– What about protecting the buyers?

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Buy-Sells and Estate Planning

• Business planning is a part of estate planning• Buy-sells play an important role for several

reasons– Legacy planning– Fixing the estate value

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Fixing the Estate Tax Value (General Rules, part 1)

• Price must be fixed or determined according to a formula which is fair and reasonable when agreement is made

• No party to the agreement can transfer during lifetime his/her interest in the company without first offering it the other parties at price set in the agreement

…..(continued)

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Fixing the Estate Tax Value (General Rules) …continued

• Estate MUST offer to sell at death at contract price– (mere OPTION to sell NOT sufficient)

• Agreement must be bona fide business agreement, and not a device to– pass decedent’s share on to the NATURAL OBJECTS OF

HIS OR HER BOUNTY for LESS THAN A FULL AND ADEQUATE CONSIDERATION

…(continued further)

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Fixing the Estate Tax Value (General Rules) …continued

• Terms of the agreement must be– Comparable to what persons

dealing “AT ARMS’ LENGTH” would do

• Family members are “the usual suspects”

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Valuation

• Separate specialized area of expertise• Who might know

– Business Owners• “if you were buying … if you were selling”• Accountant• Brokers in that area of business• Professional Appraiser: especially gives

credibility to the number

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General Methods of Valuation

• Book Value• Earnings Based Formulae – Capitalization• Dividend Paying Capacity• Multiple Formula• Appraisal• Revenue Ruling 59-60

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Types of Buy Sell Agreements

• Entity Purchase / Stock Redemption

• Cross Purchase• Wait-and-See Approach

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Entity Purchase Agreement

• An agreement between the business and its owners

• An entity purchase agreement between a corporation and its shareholders is commonly known as a Stock Redemption

• If funded with life insurance, the business is the owner and beneficiary

– “Employer” owned life insurance must comply with “EOLI” rules

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Owner BOwner B$50k Basis$50k Basis

InsurerInsurer

Owner B, Owner B, Family or Family or

EstateEstate

3. Policy Proceeds

C CorpC Corp($1 million)($1 million)

2. Buy Insurance on A & B

5. Transfer Ownership Interest

Stock Redemption

Owner AOwner A$50k Basis$50k Basis

1. Buy-Sell Agreement

4. Pay Buy-Out Price

Case Study – C Corp Redemption

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Results At Death

• No income tax to B’s Estate

• A owns business outright

• A’s basis remains at $50,000

Stock Redemption

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Owner BOwner B$50k Basis$50k Basis

GuardianGuardian

Owner B, Owner B, Family or Family or

EstateEstate

3. Policy Proceeds

S Corp, LLC S Corp, LLC or or

PartnershipPartnership($1 million)($1 million)

2. Buy Insurance on A & B

5. Transfer Ownership Interest

Entity Purchase

Owner AOwner A$50k Basis$50k Basis

1. Buy-Sell Agreement

4. Pay Buy-Out Price

Case Study – S Corp Redemption or Partnership/LLC Entity Purchase

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Results At Death

• No income tax to B’s Estate• A owns business outright• A’s basis increases

– For S corporation, can increase to $550,000

– For partnerships and LLCs, amount of increase depends

Why?

Entity Purchase

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Results At Death• S Corporation Redemption

– B’s estate receives promissory note for payment of buy-out price

– Business elects to “terminate the tax year”

– New tax year starts with remaining shareholders

– Business receives life insurance proceeds

– Insurance proceeds increase the remaining shareholders’ basis

• Partnership or LLC Entity Buy-Out

– Complicated tax rules resulting in basis adjustment

– Insurance proceeds increase the remaining owner’s basis

Entity Purchase

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Cross Purchase

• An agreement between or among the owners of a business

• The agreement obligates the surviving owners to purchase from the departing owner or the deceased owner’s estate, his or her business interest at an agreed upon price

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InsurerInsurer

Owner B, Owner B, Family or Family or

EstateEstate

1. Buy-Sell Agreement

3. Insurance Proceeds on B’s Death

Cross Purchase

Owner AOwner A($500k policy on ($500k policy on

B)B)

Owner BOwner B($500k policy on ($500k policy on

A)A)

Owner AOwner A

2. Buy Insurance on Each Other

4. Pay Buy-Out Price

5. Transfer Ownership Interest

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Results at Death

• A receives $500,000 income tax free• A pays $500,000 to B’s Estate• No income tax to B’s Estate on the

transaction• A owns the business outright• A’s total basis is $550,000

Cross Purchase

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Wait-and-See Approach

• At the time agreement is structured, it may be difficult to determine which method is better

• The wait-and-see approach defers the choice until a triggering event occurs

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Wait-and-See Approach

• Business has first option to purchase deceased/departing owner’s interest

• If not exercised, remaining owners have the option to purchase

• If remaining owners do not purchase, the business must complete the purchase

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Owner AOwner A

InsurerInsurer

Owner B, Owner B, Family or Family or

EstateEstate

3. Policy Proceeds on B’s Death

2. Buy Insurance on Each Other

Wait-and-See Approach

Owner BOwner B

BusinessBusiness($1 million)($1 million) 1. Buy-Sell Agreement

4. Loan or Capital Contribution, if needed

5. Business has first option to buy business interest

6. Option to Buy if Business Declines

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Results at Death

It depends on choice!

Wait-and-See Approach

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Comparison of Business Continuation Arrangements

Cross Purchase Entity Purchase

Basic Mechanics

• Each owner buys policy on other owners

• Surviving owners use insurance proceeds to buy-out deceased or disabled owner

• Business buys policy on each owner• Business uses insurance proceeds to buy-

out deceased or disabled owner

Advantages • Addition to basis• No AMT concerns

• Simple to administer – fewer policies

Disadvantages • More difficult to administer – more policies (N x (N-1))

• Potential transfer-for-value concerns

• Personal funds used to pay premiums (unless bonused or split dollared)

• No addition to basis for C corporation shareholders (contrast to S corp and partnership)

• Possible AMT for C corporations• Premiums not deductible• Potential realignment of ownership control• Constructive ownership: attribution rules

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Funding a Buy-Sell Agreement

• Surplus

• Sinking fund

• Installment payments

• Borrowing

• Life and Disability Insurance

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Surplus

• Rely on Corporate Surplus and Asset Liquidity

• Uncertainty of Corporation Having Surplus at Any Given Time: i.e., No Guarantee of Funds for Premature Death

• Rely on Self Enforcement

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Sinking Fund

• Essentially, a Savings Account

• Uncertainty of Individual’s Ability to Save

• Rely on Self Enforcement

• No Guarantee of Funds for Premature Death

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Borrowing

LOANS

• Ability to Borrow Uncertain

• Cost of Borrowing Uncertain

• Interest Expense May be Excessive

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Installment

• Parties Agree to Pay The Purchase Price in Installments

• Payments Spread Over a Number of Years

• Family Must Rely on Continued Financial Health of Obligated Party

• Common As a “Fall Back” Plan

BUYER SIGNS NOTE

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Life and Disability Insurance

• Most Reliable

• Ascertainable Costs

• Cost Recovery

• Generally, Least Expensive Option

• Guarantee of Funds in the Event of Premature Death

• Cash Value Grows Tax Deferred– Supplements Lifetime Buy-out

INSURANCE FUNDING

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Conclusion

• Does your client have an Existing Agreement?

• Does your client need a review and update?

– Contract terms

– Price

– New parties

– Funding

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Thank you for your attention